Table of Contents

 

 

 

**UNITEDSTATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

----

 

**FORM 10-Q**

 

----

 

**x****           QUARTERLYREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934**

 

**FOR THE QUARTERLY PERIOD ENDED: MARCH 31,2010**

 

**-OR-**

 

**o****              TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934**

 

**Commission File No. 333-144427**

 

----

 

**SALLY HOLDINGS LLC**

(Exact name of registrant as specified in its charter)

 

----

 

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

 

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

 

----

 

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

 

Indicateby check mark whether the registrant has submitted electronically and posted onits corporate Web site, if any, every Interactive Data File required to besubmitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 ofthis chapter) during the preceding 12 months (or for such shorter period thatthe registrant was required to submit and post such files).  Yes o   No o

 

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

 

| Large accelerated filer  ̈                 |   | Accelerated filer  ̈         |
|------------------------------------------------|--------|----------------------------------|
|                                           |   |                             |
| Non-accelerated filer x                        |   | Smaller reporting company  ̈ |
| (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

 

No voting or non-voting common equity of theregistrant was held by non-affiliates of the registrant as of March 31,2010.  As of April 30, 2010, allmember units were owned by Sally Investment Holdings LLC, a wholly-ownedsubsidiary of Sally Beauty Holdings, Inc.

 

 

 

----

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 | 34       |
| ITEM 3.  QUANTITATIVE AND QUALITATIVE  DISCLOSURES ABOUT MARKET RISK                      | 52       |
| ITEM 4. CONTROLS AND PROCEDURES                                                                     | 53       |
|                                                                                                |     |
| PART  II – OTHER INFORMATION                                                                   |     |
|                                                                                                |     |
| ITEM  1. LEGAL PROCEEDINGS                                                                          | 55       |
| ITEM  1A. RISK FACTORS                                                                              | 55       |
| ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND  USE OF PROCEEDS                                | 56       |
| ITEM 3. DEFAULTS UPON SENIOR SECURITIES                                                             | 56       |
| ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY  HOLDERS                                        | 56       |
| ITEM  5. OTHER INFORMATION                                                                          | 56       |
| ITEM 6. EXHIBITS                                                                                    | 57       |

 

2

----

Table of Contents

 

Since November 2006, Sally Holdings LLC, which werefer to as “Sally Holdings,” a limited liability company organized under thelaws of the State of Delaware, has been a wholly-owned subsidiary of SallyInvestment Holdings LLC, which we refer to as “Sally Investment,” awholly-owned subsidiary of Sally Beauty Holdings, Inc., which we refer toas “Sally Beauty.” All of the interests of Sally Holdings are beneficiallyowned by Sally Investment, and all of the interests of Sally Investment arebeneficially owned by Sally Beauty. Prior to November 2006, Sally Holdings was a Delaware corporationnamed “Sally Holdings, Inc.” and was a wholly-owned subsidiary of theAlberto-Culver Company, which we refer to as “Alberto-Culver.” In November 2006,Sally Holdings, Inc. was converted to a Delaware limited liabilitycompany, was renamed “Sally Holdings LLC” and became a wholly-owned subsidiaryof Sally Investment and an indirect subsidiary of Sally Beauty in connectionwith the separation of Sally Holdings’ business from Alberto-Culver. Alloperations of Sally Investment and Sally Beauty are conducted through SallyHoldings and its consolidated subsidiaries.

 

In this Quarterly Report,references to the “Company,” “Sally Holdings,” “our company,” “we,” “our,” “ours”and “us” refer to Sally Holdings LLC and its consolidated subsidiaries forperiods after the separation from Alberto-Culver and to Sally Holdings, Inc.and its consolidated subsidiaries for periods prior to the separation fromAlberto-Culver unless otherwise indicated or the context otherwise requires.

 

Cautionary Notice Regarding Forward-Looking Statements

 

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

 

Readers are cautioned notto place undue reliance on forward-looking statements as such statements speakonly as of the date they were made. Any forward-looking statements involverisks and uncertainties that could cause actual events or results to differmaterially from the events or results described in the forward-lookingstatements, including, but not limited to, risks and uncertainties related to:

 

·                  thehighly competitive nature of, and the increasing consolidation of, the beautyproducts distribution industry;

 

·                  anticipatingchanges in consumer preferences and buying trends and managing our productlines and inventory;

 

·                  potentialfluctuation in our same store sales and quarterly financial performance;

 

·                  ourdependence upon manufacturers who may be unwilling or unable to continue tosupply products to us;

 

·                  thepossibility of material interruptions in the supply of beauty supply productsby our manufacturers;

 

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

 

·                  compliancewith laws and regulations or becoming subject to additional or more stringentlaws and regulations;

 

·                  productdiversion;

 

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

 

·                  thesuccess of our internet-based business;

 

·                  successfullyidentifying acquisition candidates or successfully completing desirableacquisitions;

 

·                  integratingbusinesses acquired in the future;

 

·                  openingand operating new stores profitably;

 

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

 

·                  thesuccess of our cost control plans;

 

·                  protectingour intellectual property rights, specifically our trademarks;

 

·                  conductingbusiness outside the United States;

 

·                  disruptionin our information technology systems;

 

3

----

Table of Contents

 

·                  naturaldisasters or acts of terrorism;

 

·                  thepreparedness of our accounting and other management systems to meet financialreporting and other requirements and the upgrade of our existing financialreporting system;

 

·                  we,along with Sally Capital Inc., are holding companies with no operations of ourown, and we depend on our subsidiaries for cash;

 

·                  oursubstantial indebtedness;

 

·                  thepossibility that we may incur substantial additional debt;

 

·                  restrictionsand limitations in the agreements and instruments governing our debt;

 

·                  generatingthe significant amount of cash needed to service all of our debt andrefinancing all or a portion of our indebtedness or obtaining additionalfinancing;

 

·                  changesin interest rates increasing the cost of servicing our debt or increasing ourinterest expense due to our interest rate swap agreements;

 

·                  thepotential impact on us if the financial institutions we deal with becomeimpaired;

 

·                  therepresentativeness of our historical consolidated financial information withrespect to our future financial position, results of operations or cash flows;

 

·                  ourreliance upon Alberto-Culver for the accuracy of certain historical servicesand information;

 

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

 

·                  actionstaken by certain large stockholders of Sally Beauty adversely affecting thetax-free nature of the share distribution of Alberto-Culver common stock;

 

·                  thevoting power of Sally Beauty’s largest stockholder discouraging third-partyacquisitions of Sally Beauty at a premium; and

 

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

 

Additional factors thatcould cause actual events or results to differ materially from the events orresults described in the forward-looking statements can be found in our AnnualReport on Form 10-K for the fiscal year ended September 30, 2009, asfiled with the Securities and Exchange Commission. The events described in theforward-looking statements might not occur or might occur to a different extentor at a different time than we have described. As a result, our actual resultsmay differ materially from the results contemplated by these forward-lookingstatements. We assume no obligation to publicly update or revise anyforward-looking statements.

 

4

----

Table of Contents

 

**PART I — FINANCIAL INFORMATION**

** **

**Item 1.  Financial Statements.**

 

The following are our consolidated balance sheets as of March 31,2010 and September 30, 2009, our consolidated statements of earnings forthe three and six months ended March 31, 2010 and 2009 and ourconsolidated statements of cash flows for the six months ended March 31,2010 and 2009.  In November 2006,Sally Holdings, Inc. was converted to a Delaware limited liabilitycompany, was renamed “Sally Holdings LLC,” which we refer to as Sally Holdings,and became an indirect wholly-owned subsidiary of Sally Beauty Holdings, Inc.in connection with our separation from Alberto-Culver.  In these financial statements and elsewherein this Quarterly Report on Form 10-Q, we refer to these transactions asthe Separation Transactions.  See theCompany’s Annual Report on Form 10-K for the fiscal year ended September 30,2009 for additional information about the Separation Transactions.

 

5

----

Table of Contents

 

**SALLY HOLDINGS LLC AND SUBSIDIARIES**

Consolidated Statements of Earnings

(In thousands)

(Unaudited)

 
| ** **                                      | ** ** | **Three  Months Ended** | ** ** | **Six Months  Ended** | ** ** |
|-------------------------------------------------|------------|-------------------------|------------|-----------------------|------------|
| ** **                                      | ** ** | **March 31,**      | ** ** | **March 31,**    | ** ** |
| ** **                                      | ** ** | **2010**                | ** ** | **2009**              | ** ** | **2010** | ** ** | **2009** | ** ** |
| Net sales                                       |       | $                       | 720,467    |                  | $          | 641,511 |   | $ | 1,425,318 |   | $ | 1,287,087 |   |
| Cost of products sold and distribution expenses |       | 376,183                 |       | 339,399               |       | 747,819 |   | 681,431 |   |
| Gross profit                                    |       | 344,284                 |       | 302,112               |       | 677,499 |   | 605,656 |   |
| Selling, general and administrative expenses    |       | 245,485                 |       | 216,474               |       | 494,226 |   | 440,011 |   |
| Depreciation and amortization                   |       | 12,430                  |       | 11,471                |       | 24,319 |   | 23,218 |   |
| Operating earnings                              |       | 86,369                  |       | 74,167                |       | 158,954 |   | 142,427 |   |
| Interest expense, net                           |       | 28,414                  |       | 31,958                |       | 56,865 |   | 71,631 |   |
| Earnings before provision for income taxes |       | 57,955                  |       | 42,209                |       | 102,089 |   | 70,796 |   |
| Provision for income taxes                      |       | 22,089                  |       | 16,470                |       | 38,861 |   | 27,850 |   |
| Net earnings                                    |       | $                       | 35,866     |                  | $          | 25,739 |   | $ | 63,228 |   | $ | 42,946 |   |

 

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, 2009, arean integral part of these financial statements.

 

6

----

Table ofContents

 

**SALLY HOLDINGS LLC AND SUBSIDIARIES**

Consolidated Balance Sheets

(In thousands)

 
| ** **                                                                                                                               | ** ** | **March 31,********2010** | ** ** | **September 30,********2009** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------|------------|------------------------------------|------------|
| ** **                                                                                                                               | ** ** | **(Unaudited)**                | ** ** | ** **                         | ** ** |
| **Assets**                                                                                                                               |       |                           |       |                               |       |
| Current assets:                                                                                                                          |       |                           |       |                               |       |
| Cash and cash equivalents                                                                                                                |       | $                              | 37,420     |                               | $          | 54,447 |   |
| Trade accounts receivable,  less allowance for doubtful accounts of $2,259 at March 31, 2010 and  $2,266 at September 30, 2009 |       | 48,024                         |       | 43,649                             |       |
| Other receivables                                                                                                                        |       | 32,628                         |       | 24,090                             |       |
| Inventories                                                                                                                              |       | 578,953                        |       | 559,689                            |       |
| Prepaid expenses                                                                                                                         |       | 19,946                         |       | 18,261                             |       |
| Deferred income tax assets                                                                                                               |       | 15,732                         |       | 15,629                             |       |
| Total current assets                                                                                                                     |       | 732,703                        |       | 715,765                            |       |
| Property and equipment,  net of accumulated depreciation of $281,784 at March 31, 2010 and  $265,329 at September 30, 2009     |       | 164,893                        |       | 151,249                            |       |
| Goodwill                                                                                                                                 |       | 485,934                        |       | 494,135                            |       |
| Intangible assets, net of  accumulated amortization of $28,468 at March 31, 2010 and $24,357 at  September 30, 2009            |       | 99,970                         |       | 78,685                             |       |
| Other assets                                                                                                                             |       | 46,313                         |       | 50,676                             |       |
| Total assets                                                                                                                             |       | $                              | 1,529,813  |                               | $          | 1,490,510 |   |
| **Liabilities  and Member’s Deficit**                                                                                               |       |                           |       |                               |       |
| Current liabilities:                                                                                                                     |       |                           |       |                               |       |
| Current maturities of  long-term debt                                                                                                    |       | $                              | 3,590      |                               | $          | 24,517 |   |
| Accounts payable                                                                                                                         |       | 202,823                        |       | 193,592                            |       |
| Accrued expenses                                                                                                                         |       | 158,594                        |       | 153,842                            |       |
| Due to Sally Beauty                                                                                                                      |       | 28,127                         |       | 22,042                             |       |
| Income taxes                                                                                                                             |       | 4,078                          |       | 5,829                              |       |
| Total current liabilities                                                                                                                |       | 397,212                        |       | 399,822                            |       |
| Long-term debt                                                                                                                           |       | 1,635,497                      |       | 1,653,013                          |       |
| Other liabilities                                                                                                                        |       | 44,027                         |       | 43,586                             |       |
| Deferred income tax  liabilities                                                                                                         |       | 37,757                         |       | 34,428                             |       |
| Total liabilities                                                                                                                        |       | 2,114,493                      |       | 2,130,849                          |       |
| Stock options subject to  redemption                                                                                                     |       | 1,763                          |       | 1,800                              |       |
| Member’s deficit:                                                                                                                   |       |                           |       |                               |       |
|                                                                                                                                     |       |                           |       |                               |       |
| Member’s deficit                                                                                                                    |       | (563,013                       | )          | (626,241                           | )          |
|                                                                                                                                     |       |                           |       |                               |       |
| Accumulated other  comprehensive loss                                                                                                    |       | (23,430                        | )          | (15,898                            | )          |
| Total member’s deficit                                                                                                              |       | (586,443                       | )          | (642,139                           | )          |
| Total liabilities and  member’s deficit                                                                                             |       | $                              | 1,529,813  |                               | $          | 1,490,510 |   |

 

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, 2009, arean integral part of these financial statements.

 

7

----

Table ofContents

 

**SALLY HOLDINGS LLC AND SUBSIDIARIES**

Consolidated Statements of Cash Flows

(In thousands)

(Unaudited)

 
| ** **                                                                                           | ** ** | **Six Months  Ended March 31,** | ** ** |
|------------------------------------------------------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                                                           | ** ** | **2010**                             | ** ** | **2009** | ** ** |
| **Cash Flows  from Operating Activities:**                                                           |       |                                 |       |   |   |
| Net earnings                                                                                         |       | $                                    | 63,228     |   | $ | 42,946 |   |
| Adjustments to reconcile  net earnings to net cash provided by operating activities:                 |       |                                 |       |   |   |
| Depreciation and  amortization                                                                       |       | 24,319                               |       | 23,218 |   |
| Share-based compensation  expense (net of deferred tax benefit of $2,461 in 2010 and $1,365 in 2009) |       | 4,592                                |       | 3,527 |   |
| Amortization of deferred  financing costs                                                            |       | 3,975                                |       | 4,201 |   |
| Excess tax (benefit)  shortfall from share-based compensation                                        |       | (25                                  | )          | 226 |   |
| Net gain on disposal of  leaseholds and other property                                               |       | (26                                  | )          | (18 | ) |
| Net loss on extinguishment  of debt                                                                  |       | 376                                  |       | — |   |
| Deferred income taxes                                                                                |       | 5,119                                |       | 1,036 |   |
| Changes in (exclusive of  effects of acquisitions):                                                  |       |                                 |       |   |   |
| Trade accounts receivable                                                                            |       | 7,801                                |       | 5,761 |   |
| Other receivables                                                                                    |       | (9,163                               | )          | (10,108 | ) |
| Inventories                                                                                          |       | (10,557                              | )          | 39,716 |   |
| Prepaid expenses                                                                                     |       | (1,291                               | )          | 1,735 |   |
| Other assets                                                                                         |       | 26                                   |       | 801 |   |
| Accounts payable and  accrued expenses                                                               |       | 8,698                                |       | 17,972 |   |
| Income taxes                                                                                         |       | (3,706                               | )          | (5,886 | ) |
| Due to Sally Beauty                                                                                  |       | (1,006                               | )          | 5,495 |   |
| Other liabilities                                                                                    |       | 576                                  |       | (6,038 | ) |
| Net cash provided by  operating activities                                                           |       | 92,936                               |       | 124,584 |   |
| **Cash Flows  from Investing Activities:**                                                           |       |                                 |       |   |   |
| Capital expenditures                                                                                 |       | (23,162                              | )          | (16,789 | ) |
| Proceeds from sale of  property and equipment                                                        |       | 54                                   |       | 66 |   |
| Acquisitions, net of cash  acquired                                                                  |       | (34,936                              | )          | (1,987 | ) |
| Net cash used by investing  activities                                                               |       | (58,044                              | )          | (18,710 | ) |
| **Cash Flows  from Financing Activities:**                                                           |       |                                 |       |   |   |
| Change in book cash  overdraft                                                                       |       | 305                                  |       | (1,633 | ) |
| Proceeds from issuance of  long-term debt                                                            |       | 219,000                              |       | 94,639 |   |
| Repayments of long-term  debt                                                                        |       | (270,518                             | )          | (192,995 | ) |
| Excess tax benefit  (shortfall) from share-based compensation                                        |       | 25                                   |       | (226 | ) |
| Net cash used by financing  activities                                                               |       | (51,188                              | )          | (100,215 | ) |
| Effect of foreign exchange  rate changes on cash and cash equivalents                                |       | (731                                 | )          | (769 | ) |
| Net (decrease) increase in  cash and cash equivalents                                                |       | (17,027                              | )          | 4,890 |   |
| Cash and cash equivalents,  beginning of period                                                      |       | 54,447                               |       | 99,788 |   |
| Cash and cash equivalents,  end of period                                                            |       | $                                    | 37,420     |   | $ | 104,678 |   |
|                                                                                                 |       |                                 |       |   |   |
| **Supplemental  Cash Flow Information:**                                                             |       |                                 |       |   |   |
|                                                                                                 |       |                                 |       |   |   |
| Interest paid                                                                                        |       | $                                    | 57,068     |   | $ | 68,976 |   |
| Income taxes paid, net                                                                               |       | $                                    | 3,811      |   | $ | 4,109 |   |

 

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, 2009, are an integral part of these financialstatements.

 

8

----

Table of Contents

 

Sally Holdings LLC and Subsidiaries

Condensed Notes to Consolidated Financial Statements

(Unaudited)

 

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

 

**Description of Business**

 

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

 

Sally Beauty was formedin June 2006 and became the accounting successor company to Sally Holdings, Inc.upon the completion of the Separation Transactions. Please see the Company’sAnnual Report on Form 10-K for the fiscal year ended September 30,2009 for more information about the Separation Transactions.

 

In the ordinary course ofbusiness, the Company performs certain administrative services on behalf ofSally Beauty. These services are charged to Sally Beauty and netted against theamount due to Sally Beauty.  In addition,we have entered into a tax sharing agreement and we file consolidated taxreturns with our indirect parent, Sally Beauty. See the Company’s Annual Report on Form 10-K for the fiscal yearended September 30, 2009 for more information about related parties.

 

**Basis of Presentation**

 

The consolidated interim financial statements include the accounts ofthe Company and its subsidiaries. All significant inter-company accounts andtransactions have been eliminated in consolidation. In the opinion of management,these consolidated financial statements reflect all adjustments which are of anormal recurring nature and which are necessary to present fairly theconsolidated financial position as of March 31, 2010 and September 30,2009, the consolidated results of operations for the three and six months endedMarch 31, 2010 and 2009 and the consolidated cash flows for the six monthsended March 31, 2010 and 2009.

 

All references in these notes to “management” are to the management ofSally Holdings. All references in these notes to the “Company” are to SallyHoldings.

 

##### ***2.  ***SignificantAccounting Policies

##### *** ***

##### ***Accounting Principles***

##### *** ***

The consolidated interimfinancial statements included herein are unaudited and have been prepared bythe Company pursuant to the rules and regulations of the Securities andExchange Commission (“SEC”). Certain information and note disclosures normallyincluded in annual financial statements prepared in accordance with accountingprinciples generally accepted in the United States (“GAAP”) have been condensedor omitted pursuant to those rules and regulations, although the Companybelieves that the disclosures made are adequate to make the information notmisleading. These consolidated interim financial statements should be read inconjunction with the financial statements and notes thereto included in theCompany’s Annual Report on Form 10-K for the fiscal year ended September 30,2009. The Company adheres to the same accounting policies in the preparation ofits interim financial statements. As permitted under GAAP, interim accountingfor certain expenses, including income taxes, is based on full yearassumptions. Such amounts are expensed in full in the year incurred.  For interim financial reporting purposes,income taxes are recorded based upon estimated annual effective income taxrates.

 

The results of operationsfor these interim periods are not necessarily indicative of the results thatmay be expected for any future interim period or the entire fiscal year.

 

9

----

Table of Contents

 

Sally Holdings LLC and Subsidiaries

Condensed Notes to Consolidated Financial Statements

(Unaudited)

 

The Company’s financialinstruments consist of cash and cash equivalents, trade and other accountsreceivable, accounts payable, interest rate swap agreements, foreign currencyoptions and long-term debt. There were no significant changes in the methodsand significant assumptions used to estimate the fair value of the Company’sfinancial instruments since September 30, 2009.

 

The carrying amounts ofcash and cash equivalents, trade and other accounts receivable and accountspayable approximate fair value due to the short-term nature of these financialinstruments.

 

The aggregate fair value of the interestrate swap agreements held at March 31, 2010 was a net liability of $15.1million included in other liabilities in the Company’sconsolidated balance sheet. Fair valueamounts reported for these agreements are based on third-party information andwere determined using proprietary models based upon well-recognized financialprinciples and reasonable estimates about relevant future market conditions.Please see Note 7 for more information about the Company’s interest rate swaps.

 

##### ***The aggregate fair value of all foreigncurrency option agreements held at March 31, 2010 was a net asset of $0.4million included in prepaid expenses in the***Company’s consolidated balancesheet. Fair value amounts reported for these agreementsare based on third-party information and were determined using proprietarymodels based upon well-recognized financial principles and reasonable estimatesabout relevant future market conditions. Please see Note 7 for more informationabout the Company’s foreign currency options.

##### *** ***

##### ***At March 31, 2010, the fairvalue of the Company’s long-term debt (including capital leases) wasapproximately $1,675.3 million, while the carrying amount in the Company’sconsolidated balance sheet was $1,639.1 million. Fair value amounts reportedfor long-term borrowings are based on quoted market prices where available or,if not available, based on discounted future cash flows using current marketinterest rates.***

##### *** ***

As required by AccountingStandards Codification (“ASC”) 815,*Derivatives and Hedging*,as amended, the Company records all derivative instruments on its balance sheetat fair value.  The accounting for changes in the fair value of derivativeinstruments depends on the intended use of the derivative, whether the Companyhas elected to designate a derivative instrument in a hedging relationship andapply hedge accounting, and whether the hedging relationship has satisfied thecriteria necessary to apply hedge accounting. Derivative instruments designatedand qualifying as a hedge of the exposure to variability in expected futurecash flows, or other types of forecasted transactions, are considered cash flowhedges. Hedge accounting generally provides for the matching of the timing ofgain or loss recognition on the hedging instrument with the recognition of theimpact on earnings of the hedged transaction or transactions. The Company mayfrom time to time enter into derivative contracts that are intended to hedgecertain economic risks even though hedge accounting does not apply or theCompany elects not to apply hedge accounting to such derivative contracts.Please see Note 7 for more details about the Company’s derivative instrumentsand hedging activities as of March 31, 2010.

 

In the fiscal year 2009,the Company adopted the provisions of ASC 820, *Fair ValueMeasurements and Disclosures*(“ASC 820”), as it relates to itsfinancial instruments.  ASC 820, asamended, establishes a three-level hierarchy for measuring fair value andrequires an entity to maximize the use of observable inputs and minimize theuse of unobservable inputs when measuring fair 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:

 

Level1 - Unadjustedquoted prices in active markets for identical assets or liabilities;

 

Level2 - Unadjustedquoted prices in active markets for similar assets or liabilities; orunadjusted quoted prices for identical or similar assets or liabilities inmarkets that are not active; or inputs other than quoted prices that areobservable for the asset or liability; or inputs that are derived principallyfrom or corroborated by observable market data; and

 

Level3 - Unobservableinputs for the asset or liability

 

The Company measurescertain financial instruments at fair value on a recurring basis, includinginterest rate swaps and foreign currency options. In accordance with ASC 820,the Company categorized certain of its financial assets 

 

10

----

Table of Contents

 

Sally Holdings LLC and Subsidiaries

Condensed Notes to Consolidated Financial Statements

(Unaudited)

 

and liabilities, based onpriority of the inputs to the valuation technique for the instruments, asfollows at March 31, 2010 (in thousands):

 
| ** **                     | ** ** | **As of  March 31, 2010** | ** ** |
|--------------------------------|------------|--------------------------------|------------|
| ** **                     | ** ** | **Total**                      | ** ** | **Level 1** | ** ** | **Level 2** | ** ** | **Level 3** | ** ** |
| Assets                         |       |                           |       |   |   |   |   |   |   |
| Foreign currency options (b)   |       | $                              | 383        |   |   |   | $ | 383 |   |   |   |
| Total assets                   |       | $                              | 383        |   |   |   | $ | 383 |   |   |   |
|                           |       |                           |       |   |   |   |   |   |   |
| Liabilities                    |       |                           |       |   |   |   |   |   |   |
| Long-term debt (a)             |       | $                              | 1,675,311  |   | $ | 755,550 |   | $ | 919,761 |   |   |   |
| Hedged interest rate swaps (b) |       | 15,104                         |       | — |   | 15,104 |   |   |   |
| Total liabilities              |       | $                              | 1,690,415  |   | $ | 755,550 |   | $ | 934,865 |   |   |   |

 

----

(a)          Long-term debt,which is carried at amortized cost in the Company’s financial statements, isvalued using internal models based on market observable inputs, except for thesenior and senior subordinated notes. The senior and senior subordinated notesare valued using quoted market prices for such debt securities.

(b)         Interest rateswaps and foreign currency options are valued using internal models based onmarket observable inputs, including market interest rates and foreign currencyexchange rates, as appropriate. Please see Note 7 for more information aboutthe Company’s interest rate swaps and foreign currency options.

 

The Company categorizedcertain of its financial assets and liabilities, based on priority of theinputs to the valuation technique for the instruments, as follows at September 30,2009 (in thousands):

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

 

----

(a)          Long-term debt,which is carried at amortized cost in the Company’s financial statements, isvalued using internal models based on market observable inputs, except for thesenior and senior subordinated notes. The senior and senior subordinated notesare valued using quoted market prices for such debt securities.

 

(b)         Interest rateswaps are valued using internal models based on market observable inputs,including market interest rates. Please see Note 7 for more information aboutthe Company’s interest rate swaps.

 

**RecentAccounting Pronouncements**

 

In December 2007,the Financial Accounting Standards Board (“FASB”) revised the accountingstandards for business combinations. This new standard (currently contained inASC 805, *Business Combinations*(“ASC 805”)),among other things, generally requires that an acquirer recognize the assetsacquired and liabilities assumed measured at their “full fair values” on theacquisition date. This practice replaced the practice, under predecessoraccounting standards, of allocating the cost of an acquisition to theindividual assets acquired and liabilities assumed based on their relativeestimated fair values.  This new standardfurther requires that acquisition-related costs be recognized separately fromthe related acquisition. The Company adopted this standard during the first quarterof the fiscal year 2010. Selling, general and administrative expenses for thesix months ended March 31, 2010 includes approximately $0.5 million ofexpenses related to acquisitions.

 

##### ***In April 2008, the FASBamended ASC 350,***Intangibles and Other (“ASC 350”). This new accountingstandard, currently contained in ASC 350-30-35, specifically amends the factorsthat should be considered in developing renewal or extension assumptions usedto determine the useful life of a recognized intangible asset. The objective ofthis amendment is to improve the consistency between the useful life of arecognized intangible asset and the period of expected cash flows used tomeasure the fair value of the asset. The Company adopted this standard duringthe 

 

11

----

Table of Contents

 

Sally Holdings LLC and Subsidiaries

Condensed Notes to Consolidated Financial Statements

(Unaudited)

 

##### ***first quarter of thefiscal year 20***10 and its adoption did not have amaterial effect on the Company’s consolidated financial position, results of operations or cash flows.

##### *** ***

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

 

##### ***In January 2010, the FASBissued ASU No. 2010-06 which amended ASC 820 as it relates to certaindisclosures of fair value measurements. This amendment requires, among otherthings, (a) disclosure of the sensitivity of an entity’s fair valuemeasurements using Level 3 inputs to changes in such inputs, (b) areconciliation of changes in such fair value measurements and (c) disclosureof transfers between fair value measurements using Level 1 and 2 inputs, ifany. The Company adopted this amendment during the***second quarter of the fiscal year 2010 and its adoption did not have amaterial effect on the Company’s consolidated financial position, results of operations or cash flows.

##### *** ***

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

 

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

##### *** ***

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

 
| ** **                                      | ** ** | **Three Months Ended********March 31,** | ** ** | **Six Months Ended********March 31,** | ** ** |
|-------------------------------------------------|------------|--------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                      | ** ** | **2010**                                               | ** ** | **2009**                                             | ** ** | **2010** | ** ** | **2009** | ** ** |
| Net earnings                                    |       | $                                                      | 35,866     |                                                 | $          | 25,739 |   | $ | 63,228 |   | $ | 42,946 |   |
| Other comprehensive (loss) income adjustments:  |       |                                                   |       |                                                 |       |   |   |   |   |
| Foreign currency translation adjustments (a)    |       | (9,250                                                 | )          | (7,227                                               | )          | (7,691 | ) | (39,510 | ) |
| Deferred (loss) gain on interest rate swaps (b) |       | (673                                                   | )          | (1,336                                               | )          | 159 |   | (12,209 | ) |
| Comprehensive income (loss)                     |       | $                                                      | 25,943     |                                                 | $          | 17,176 |   | $ | 55,696 |   | $ | (8,773 | ) |

 

----

(a)          There were noincome tax amounts related to foreign currency translation adjustments recordedin other comprehensive income (loss) for the three and six months ended March 31,2010 and 2009.

 

(b)         Amounts are netof income tax benefit of $0.4 million and $0.7 million for the three monthsended March 31, 2010 and 2009, and net of income tax expense of $0.1million and net of income tax benefit of $7.7 million for the six months ended March 31,2010 and 2009, respectively.

 

12

----

Table of Contents

 

Sally Holdings LLC and Subsidiaries

Condensed Notes to Consolidated Financial Statements

(Unaudited)

 

The components ofaccumulated other comprehensive (loss) income as of March 31, 2010 and September 30,2009 are as follows (in thousands):

 
| ** **                                           | ** ** | **As of March 31, 2010** | ** ** | **As of September 30, 2009** | ** ** |
|------------------------------------------------------|------------|-------------------------------|------------|-----------------------------------|------------|
| ** **                                           | ** ** | **Amount  Before Tax**        | ** ** | **Deferred********Tax**           | ** ** | **Net********Amount** | ** ** | **Amount  Before Tax** | ** ** | **Deferred********Tax** | ** ** | **Net********Amount** | ** ** |
| Cumulative foreign currency  translation adjustments |       | $                             | (14,186    | )                                 | —     |   | $ | (14,186 | ) | $ | (6,495 | ) | — |   | $ | (6,495 | ) |
| Deferred (losses) gains on interest rate swaps (a)   |       | (15,104                       | )          | 5,860                             |       | (9,244 | ) | (15,365 | ) | 5,962 |   | (9,403 | ) |
| Total accumulated other comprehensive (loss) income  |       | $                             | (29,290    | )                                 | $          | 5,860 |   | $ | (23,430 | ) | $ | (21,860 | ) | $ | 5,962 |   | $ | (15,898 | ) |
|                                                      |            |                               |            |                                   |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

----

## **(a)**          See Note 7 for more informationabout our interest rate swaps.

##  

##### ***4.  Share-BasedPayments***

##### *** ***

Since November 16,2006, the Company has been an indirect wholly-owned subsidiary of Sally Beautyand has no share based plans of its own; however, certain employees andconsultants of the Company have been granted stock options and share awardsunder the plans of Sally Beauty.

 

The Company accounts forstock option and stock awards, which include share-based payment plans, inaccordance with ASC 718, *Compensation — StockCompensation.* Accordingly, the Company measures the cost of employeeservices received in exchange for an award of equity instruments based on thefair value of the award on the grant date and recognizes compensation expenseon a straight-line basis over the vesting period or to the date a participantbecomes eligible for retirement, if earlier. On January 27, 2010, SallyBeauty adopted the Sally Beauty Holdings, Inc. 2010 Omnibus Incentive Plan(the “2010 Plan”), a share-based compensation plan which allows for theissuance of up to 29.8 million shares of Sally Beauty’s common stock.

 

Sally Beauty grantedapproximately 2.9 million and 2.7 million stock options to the Company’semployees and consultants during the six months ended March 31, 2010 and2009, respectively. These amounts include 2.3 million stock options under theSally Beauty Holdings 2007 Omnibus Incentive Plan (the “2007 Plan”), 0.5million stock options under the Alberto-Culver Company Employee Stock OptionPlan of 2003 (the “2003 Plan”) and 0.1 million stock options under the 2010Plan. Upon issuance of such grants, the Company recognized acceleratedshare-based compensation expense of $2.5 million and $2.0 million in the fiscalyears 2010 and 2009, respectively, in connection with certain retirementeligible employees who are eligible to continue vesting awards upon retirementunder the terms contained in the 2010 Plan and certain predecessor share-basedcompensation plans.

 

The following tablepresents the total compensation cost charged against income and included inselling, general and administrative expenses for share-based compensationarrangements and the related tax benefits recognized in our statements ofearnings (in thousands):

 
| ** **                                                      | ** ** | **Three Months Ended********March 31,** | ** ** | **Six Months Ended********March 31,** | ** ** |
|-----------------------------------------------------------------|------------|----------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                      | ** ** | **2010**                                     | ** ** | **2009**                                   | ** ** | **2010** | ** ** | **2009** | ** ** |
|                                                            |       |                                         |       |                                       |       |   |   |   |   |
| Share-based compensation expense                                |       | $                                            | 2,231      |                                       | $          | 1,424 |   | $ | 7,054 |   | $ | 4,892 |   |
| Income tax benefit related to share-based  compensation expense |       | $                                            | 688        |                                       | $          | 43 |   | $ | 2,461 |   | $ | 1,365 |   |

 

## **StockOptions**

##  

Each option has anexercise price that equals 100% of the market price of Sally Beauty’s commonstock on the date of grant and generally has a maximum term of 10 years.Options generally vest ratably over a four year period and 

 

13

----

Table of Contents

 

Sally Holdings LLC and Subsidiaries

Condensed Notes to Consolidated Financial Statements

(Unaudited)

 

are generally subject toforfeiture until the four year vesting period is complete, subject to certainretirement provisions contained in the 2010 Plan and certain predecessorshare-based compensation plans.

 

The following tablepresents a summary of the activity for Sally Beauty’s stock options issued to theCompany’s employees and consultants for the six months ended March 31,2010:

 
| ** **                              | ** ** | **Number of  Outstanding  Options (in  Thousands)** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Weighted  Average  Remaining  Contractual  Term (in  Years)** | ** ** | **Aggregate  Intrinsic  Value (in  Thousands)** | ** ** |
|-----------------------------------------|------------|-----------------------------------------------------|------------|----------------------------------------|------------|-----------------------------------------------------------------|------------|-------------------------------------------------|------------|
| Outstanding at  September 30, 2009 |       | 10,025                                              |       | $                                      | 7.40       |                                                            | 7.7        |                                            | $          | 10,678 |   |
| Granted                                 |       | 2,917                                               |       | 7.46                                   |       |                                                            |       |                                            |       |
| Exercised                               |       | (27                                                 | )          | 2.59                                   |       |                                                            |       |                                            |       |
| Forfeited or expired                    |       | (40                                                 | )          | 9.09                                   |       |                                                            |       |                                            |       |
| Outstanding at  March 31, 2010     |       | 12,875                                              |       | $                                      | 7.42       |                                                            | 7.7        |                                            | $          | 22,053 |   |
|                                    |       |                                                |       |                                   |       |                                                            |       |                                            |       |
| Exercisable at March 31,  2010     |       | 5,914                                               |       | $                                      | 7.51       |                                                            | 6.7        |                                            | $          | 10,416 |   |

 

The following tablesummarizes information about Sally Beauty’s stock options held by the Company’semployees and consultants under Sally Beauty’s option plans at March 31,2010:

 
| ** **                     | ** ** | **Options Outstanding**                                          | ** ** | **Options Exercisable**                                         | ** ** |
|--------------------------------|------------|------------------------------------------------------------------|------------|-----------------------------------------------------------------|------------|
| **Range of  Exercise  Prices** | ** ** | **Number  Outstanding at  March 31,  2010 (in  Thousands)** | ** ** | **Weighted  Average  Remaining  Contractual  Term (in  Years)** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Number  Exercisable  at March 31,  2010 (in  Thousands)** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
| $2.00                          |       | 1,122                                                            |       | 4.3                                                             |       | $ | 2.00 |   | 1,122 |   | $ | 2.00 |   |
| $5.24 – 9.66              |       | 11,753                                                           |       | 8.1                                                             |       | 7.94 |   | 4,792 |   | 8.80 |   |
| Total                          |       | 12,875                                                           |       | 7.7                                                             |       | $ | 7.42 |   | 5,914 |   | $ | 7.51 |   |

 

The Company uses theBlack-Scholes option pricing model to value Sally Beauty’s stock options foreach stock option award. Using this option pricing model, the fair value ofeach stock option award is estimated on the date of grant. The fair value ofSally Beauty’s stock option awards, which generally vest ratably over a fouryear period, is expensed on a straight-line basis over the vesting period ofthe stock options or to the date a participant becomes eligible for retirement,if earlier.

 

The weighted averageassumptions relating to the valuation of Sally Beauty’s stock options are asfollows:

 
| ** **                | ** ** | **Six Months  Ended March 31,** | ** ** |
|---------------------------|------------|--------------------------------------|------------|
| ** **                | ** ** | **2010**                             | ** ** | **2009** | ** ** |
| Expected lives (in years) |       | 5.0                                  |       | 5.0 |   |
| Expected volatility       |       | 64.4                                 | %     | 47.9 | % |
| Risk-free interest rate   |       | 2.4                                  | %          | 2.6 | % |
| Dividend yield            |       | 0.0                                  | %          | 0.0 | % |

 

The expected life ofoptions represents the period of time that the options granted are expected tobe outstanding and is based on historical experience of employees of theCompany who have been granted stock options, including grants under stockoption plans of Alberto-Culver prior to the Separation Transactions. Expectedvolatility is derived using the average volatility of both Sally Beauty andsimilar companies (based on industry sector) since it is not practicable toestimate Sally Beauty’s expected volatility on a stand-alone basis due to alack of sufficient trading 

 

14

----

Table of Contents

 

Sally Holdings LLC and Subsidiaries

Condensed Notes to Consolidated Financial Statements

(Unaudited)

 

history. The risk-freeinterest rate is based on the zero-coupon U.S. Treasury issue as of the date ofthe grant. Since Sally Beauty does not currently expect to pay dividends, thedividend yield is 0%.

 

The weighted average fairvalue of the Sally Beauty stock options issued to the Company’s employees andconsultants at the date of grant in the six months ended March 31, 2010and 2009 was $4.15 and $2.33 per option, respectively. The total intrinsicvalue of options exercised during the six months ended March 31, 2010 was$0.2 million. Cash proceeds from these option exercises were $0.1 million andthe tax benefit realized for the tax deductions from these option exercises was$0.1 million. 

 

At March 31, 2010,approximately $14.2 million of total unrecognized compensation costs related tounvested stock option awards are expected to be recognized over the weightedaverage period of 2.6 years.

 

## **StockAwards**

##  

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

##### *** ***

As an indirect subsidiaryof Sally Beauty, the Company has no employee stock award plans; however certainemployees (and consultants) of the Company have been granted restricted stockawards under Sally Beauty’s stock award plans. A restricted stock award is anaward of shares of Sally Beauty’s common stock (which have full voting rightsbut are restricted with regard to sale or transfer), the restrictions overwhich lapse ratably over a specified period of time (generally five years).Restricted stock awards are independent of stock option grants and aregenerally subject to forfeiture if employment terminates prior to theserestrictions lapsing, subject to certain retirement provisions contained in the2010 Plan and certain predecessor share-based compensation plans.

 

The Company expenses thecost of the restricted stock awards, which is determined to be the fair valueof the restricted stock award at the date of grant, on a straight-line basisover the period (the “vesting period”) in which the restrictions on these stockawards lapse (“vesting”). For these purposes, the fair value of the restrictedstock award is determined based on the closing price of Sally Beauty’s commonstock on the grant date.

 

The following tablepresents a summary of the activity for Sally Beauty’s restricted stock awardedto the Company’s employees (and consultants) for the six months ended March 31,2010:

 
| **Restricted Stock Awards**          | ** ** | **Number of  Shares (in  Thousands)** | ** ** | **Weighted  Average Fair  Value Per Share** | ** ** | **Weighted  Average  Remaining  Vesting Term  (in Years)** | ** ** |
|--------------------------------------|------------|---------------------------------------|------------|---------------------------------------------|------------|-----------------------------------------------------------------|------------|
| Unvested at  September 30, 2009 |       | 331                                   |       | $                                           | 7.45       |                                                            | 3.3        |   |
| Granted                              |       | 118                                   |       | 7.42                                        |       |                                                            |       |
| Vested                               |       | (81                                   | )          | 7.71                                        |       |                                                            |       |
| Forfeited                            |       | —                                |       | —                                      |       |                                                            |       |
| Unvested at March 31,  2010     |       | 368                                   |       | $                                           | 7.38       |                                                            | 3.6        |   |

 

At March 31, 2010,approximately $2.4 million of total unrecognized compensation costs related tounvested restricted stock awards are expected to be recognized over theweighted average period of 3.6 years.

 

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

##### *** ***

During the six months ended March 31, 2010, intangible assetssubject to amortization in the amount of $22.9 million and $1.9 million wererecorded in connection with the September 2009 acquisitions of SchoenemanBeauty Supply, Inc. and Distribuidora Intersalon Limitada, respectively.In addition, during the six months ended March 31, 2010, intangible assetswith indefinite lives in the amount of $0.9 million were recorded in connectionwith the acquisition of Distribuidora Intersalon Limitada. These amounts werepreviously reported in Goodwill pending the valuation of the assets acquired.Please see Note 15 to our financial statements contained in Item 8 of ourAnnual Report on Form 10-K for the fiscal year ended September 30,2009.

 

15

----

Table of Contents

 

Sally Holdings LLC and Subsidiaries

Condensed Notes to Consolidated Financial Statements

(Unaudited)

 

The change in the carrying amounts of goodwill by operating segment forthe six months ended March 31, 2010 is as follows (in thousands):

 
| ** **                                   | ** ** | **Sally Beauty  Supply** | ** ** | **Beauty Systems  Group** | ** ** | **Total** | ** ** |
|----------------------------------------------|------------|--------------------------|------------|---------------------------|------------|-----------|------------|
| Balance at September 30, 2009           |       | $                        | 73,208     |                      | $          | 420,927   |       | $ | 494,135 |   |
| Additions and purchase price adjustments (a) |       | 19,231                   |       | 1,567                     |       | 20,798    |       |
| Reclassifications                            |       | (2,780                   | )          | (22,920                   | )          | (25,700   | )          |
| Foreign currency translation                 |       | (4,854                   | )          | 1,555                     |       | (3,299    | )          |
| Balance at March 31, 2010               |       | $                        | 84,805     |                      | $          | 401,129   |       | $ | 485,934 |   |

 

----

(a)          Please see Note 9 for additional information aboutbusinesses acquired.

 

The following tableprovides the gross carrying value and accumulated amortization for intangibleassets with indefinite lives and intangible assets subject to amortization byoperating segment at March 31, 2010 (in thousands):

 
| ** **                                 | ** ** | **Sally Beauty  Supply** | ** ** | **Beauty Systems  Group** | ** ** | **Total** | ** ** |
|--------------------------------------------|------------|--------------------------|------------|---------------------------|------------|-----------|------------|
| Balance at March 31, 2010             |       |                     |       |                      |       |      |       |
| Intangible assets with indefinite lives:   |       |                     |       |                      |       |      |       |
| Trade names                                |       | $                        | 19,868     |                      | $          | 33,624    |       | $ | 53,492 |   |
| Other intangibles                          |       | —                   |       | 5,700                     |       | 5,700     |       |
| Total                                      |       | 19,868                   |       | 39,324                    |       | 59,192    |       |
| Intangible assets subject to amortization: |       |                     |       |                      |       |      |       |
| Gross carrying amount                      |       | 8,773                    |       | 60,473                    |       | 69,246    |       |
| Accumulated amortization                   |       | (3,025                   | )          | (25,443                   | )          | (28,468   | )          |
| Net value                                  |       | 5,748                    |       | 35,030                    |       | 40,778    |       |
| Total intangible assets, net               |       | $                        | 25,616     |                      | $          | 74,354    |       | $ | 99,970 |   |

 

Amortization expense was$2.2 million and $1.4 million for the three months ended March 31, 2010and 2009, and $4.1 million and $2.9 million for the six months ended March 31,2010 and 2009, respectively. As of March 31, 2010, future amortizationexpense related to intangible assets subject to amortization is estimated to beas follows (in thousands):

 
| **Fiscal Year:** |   |   |   |
|------------------|--------|--------|--------|
| 2010             |   | $      | 3,953  |   |
| 2011             |   | 7,106  |   |
| 2012             |   | 6,153  |   |
| 2013             |   | 3,683  |   |
| 2014             |   | 4,102  |   |
| Thereafter       |   | 15,781 |   |
|             |   | $      | 40,778 |   |

 

16

----

Table ofContents

 

Sally Holdings LLC and Subsidiaries

Condensed Notes to Consolidated Financial Statements

(Unaudited)

 

##### ***6.   Long-TermDebt***

##### *** ***

Details of long-term debtare as follows (in thousands):

 
| ** **                    | ** **   | **As of  March 31,  2010** | ** ** | **Maturity  dates** | ** **     | **Interest Rates**                              | ** **                                 |
|-------------------------------|--------------|---------------------------------|------------|---------------------|----------------|-------------------------------------------------|--------------------------------------------|
| ABL facility                  |         | $                               | —     |                | —         |                                            | (i)   Prime plus up to 0.50% or; |   |
|                          | * *     | * *                        |       |                |           | (ii)  LIBOR plus (1.00% to 1.50%)          |                                       |
| Term Loan A                   |         | 54,716                          |       | Nov. 2012      |           | (i)   Prime plus (1.00% to 1.50%) or; |                                       |
|                          | * *     | * *                        |       |                |           | (ii)  LIBOR plus (2.00% to 2.50%)(a)       |                                       |
| Term Loan B                   |         | 863,856                         |       | Nov. 2013      |           | (i)   Prime plus (1.25% to 1.50%) or; |                                       |
|                          | * *     | * *                        |       |                |           | (ii)  LIBOR plus (2.25% to 2.50%)(a)       |                                       |
| Other (b)                     |         | 7,576                           |       | 2010-2014           |           | 4.05% to 6.75%                                  |                                       |
| Total                         |         | $                               | 926,148    |                |           |                                            |                                       |   |
|                          | *** *** | *** ***                    |       |                |           |                                            |                                       |
| Senior notes                  |         | $                               | 430,000    |                | Nov. 2014 |                                            | 9.25%                                      |   |   |
| Senior subordinated notes     |         | 275,000                         |       | Nov. 2016      |           | 10.50%                                          |                                       |   |
| Total                         |         | $                               | 705,000    |                |           |                                            |                                       |   |
|                          | *** *** | *** ***                    |       |                |           |                                            |                                       |
| Capitalized leases and  other |         | $                               | 7,939      |                |           |                                            |                                       |   |
| Less: current portion         |         | (3,590                          | )          |                |           |                                            |                                       |
| Total long-term debt          |         | $                               | 1,635,497  |                |           |                                            |                                       |   |

 

----

(a)                            At March 31, 2010, the interest rate forboth term loan A and term loan B is 2.5%.

(b)                           Represents pre-acquisition debt of Pro-Duo NVand Sinelco Group NV. Please see Note 9.

 

In connection with theSeparation Transactions in November 2006, the Company and Sally Investmentincurred $1,850.0 million of indebtedness by (i) drawing on a revolving(asset-based lending (“ABL”)) facility in the amount of $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) together (jointly and severally) with anotherof Sally Beauty’s indirect subsidiaries, Sally Capital Inc., issuing seniornotes in an aggregate amount of $430.0 million and senior subordinated notes inan aggregate amount of $280.0 million.

 

The term loan facilitiesand the ABL facility are secured by substantially all of our assets, those ofSally Investment, those of our domestic subsidiaries and, in the case of theABL facility, those of our Canadian subsidiaries. The senior term loanfacilities may be prepaid at the option of the Company at any time withoutpremium or penalty and are subject to mandatory prepayment in an amount equalto 50% of excess cash flow (as defined in the agreement governing the term loanfacilities) for any fiscal year unless a specified leverage ratio is met. In January 2010,the Company made a mandatory prepayment on the senior term loan facilities inthe amount of $22.3 million. Amounts paid pursuant to said provision may beapplied, at the option of the Company, against minimum loan repaymentsotherwise required of us over the twelve-month period following any suchpayment under the terms of the loan agreement. Additionally, borrowings underthe term loan facility would be subject to mandatory prepayment in an amountequal to 100% of the proceeds of specified asset sales that are not reinvestedin the business or applied to repay borrowings under the ABL facility.

 

During the six monthsended March 31, 2010, the Company also made optional prepayments in theaggregate amount of $28.0 million on its senior term loans. In connection withthe mandatory and optional prepayments made during the six months ended March 31,2010, the Company recorded losses on extinguishment of debt in the aggregateamount of $0.4 million, which are included in net interest expense in theCompany’s consolidated statements of earnings.

 

Thesenior notes and senior subordinated notes are unsecured obligations of theissuers and are jointly and severally guaranteed on a senior basis (in the caseof the senior notes) and on a senior subordinated basis (in the case of thesenior subordinated notes) by each material domestic subsidiary of the Company.Furthermore, the agreements underlying the Company’s credit facilitiescontain terms which significantly restrict the ability of us and our 

 

17

----

Table of Contents

 

Sally Holdings LLC and Subsidiaries

Condensed Notes to Consolidated Financial Statements

(Unaudited)

 

subsidiaries to paydividends or otherwise transfer assets to Sally Beauty. Please see the Company’sAnnual Report on Form 10-K for the fiscal year ended September 30,2009, for additional information about the Company’s long-term debt.

 

Maturities of the Company’slong-term debt are as follows as of March 31, 2010 (in thousands):

 
| **Fiscal Year:**          |   |    |      |
|---------------------------|--------|---------|-----------|
| 2010                      |   | $       | 1,924     |   |
| 2011                      |   | 1,792   |      |
| 2012                      |   | 56,098  |      |
| 2013                      |   | 9,506   |      |
| 2014                      |   | 856,828 |      |
| Thereafter                |   | 705,000 |      |
|                      |   | $       | 1,631,148 |   |
| Capital leases  and other |   | 7,939   |      |
| Less: current  portion    |   | (3,590  | )         |
| Total                     |   | $       | 1,635,497 |   |

 

We are a holding companyand do not have any material assets or operations other than ownership ofequity interests of our subsidiaries. The agreements and instruments governingthe debt of the Company and our subsidiaries contain material limitations onour ability to pay dividends and other restricted payments to our indirectparent, Sally Beauty.

 

Under the agreements andindentures governing the term loan facilities and the notes, we may not makecertain restricted payments to Sally Beauty if a default then exists under thecredit agreement or the indentures or if our consolidated interest coverageratio is less than 2.0 to 1.0 at the time of the making of such restrictedpayment. As of March 31, 2010, our consolidated interest coverage ratioexceeded 2.0 to 1.0.  Further, theaggregate amount of restricted payments we are able to make is limited pursuantto various baskets as calculated pursuant to the credit agreement andindentures.

 

The agreements governingour ABL facility generally permit the making of distributions and certain otherrestricted payments so long as borrowing availability under the facility equalsor exceeds $60.0 million. If borrowing availability falls below this amount, wemay nevertheless make restricted payments to Sally Beauty in the aggregatesince the date of the Separation Transactions, together with the aggregate cashamount paid in acquisitions since said date, of not greater than $50.0 million,together with certain other exceptions. As of March 31, 2010, borrowingavailability under the ABL facility exceeded $60.0 million. As of March 31,2010, the net assets of the Company and its consolidated subsidiaries that wereunrestricted from transfer under our credit arrangements totaled $262.6million, subject to certain adjustments. The ABL facility and the senior termloan facilities, as well as the Company’s 9.25% Senior Notes indenture and its10.5% Senior Subordinated Notes indenture contain customary cross-default and/orcross-acceleration provisions.

 

##### ***7.   DerivativeInstruments and Hedging Activities***

##### *** ***

**RiskManagement Objectives of Using Derivative Instruments**

 

The Company is exposed to a wide variety of risks,including risks arising from changing economic conditions. The Company managesits exposure to certain economic risks (including liquidity, credit risk andchanges in interest rates) primarily (a) by closely managing its cashflows from operating and investing activities and the amounts and sources ofits debt obligations; (b) by assessing periodically the creditworthinessof its business partners; and (c) through the use of interest rateswaps.  The Company uses interest rateswaps as part of its overall economic risk management strategy to add stabilityto the interest payments due in connection with its term loan obligations.Interest payments related to the term loans are impacted by changes in LIBOR.Interest rate swap agreements involve the periodic receipt by the Company ofamounts based on a variable rate in exchange for the Company making paymentsbased on a fixed rate over the term of the interest rate swap agreements,without exchange of the underlying notional amount. As of March 31, 2010,the Company did not purchase or hold any derivative instruments for trading orspeculative purposes.

 

18

----

Table of Contents

 

Sally Holdings LLC and Subsidiaries

Condensed Notes to Consolidated Financial Statements

(Unaudited)

 

**DesignatedCash Flow Hedges**

 

In May 2008,the Company entered into two interest rate swap agreements with an aggregate notional amount of $300 million (eachagreement with a notional amount of $150 million). These agreements expire on May 31,2012 and are designated and qualify as effective cash flow hedges, inaccordance with ASC 815. Accordingly, changes in the fair value of thesederivative instruments are recorded quarterly, net of income tax, inaccumulated other comprehensive (loss) income (“OCI”) until the hedgedobligation is settled or the swap agreements expire, whichever is earlier. Anyhedge ineffectiveness, as this term is used in ASC 815, is recognized in netinterest expense in our consolidated statements of earnings. No hedgeineffectiveness on cash flow hedges was recognized during the six months ended March 31,2010 or 2009. Please see the Company’s Annual Report on Form 10-K for thefiscal year ended September 30, 2009 for additional information about theCompany’s interest rate swap agreements.

 

Amounts reported in OCI related to interest rate swapsare reclassified into net interest expense, as a yield adjustment, in the sameperiod in which interest on the Company’s variable-rate debt obligations affectearnings. Interest expense resulting from such reclassifications were $2.5million and $2.3 million during the three months ended March 31, 2010 and2009, and $5.1 million and $3.0 million during the six months ended March 31,2010 and 2009, respectively.  During thetwelve months ending March 31, 2011, the Company estimates that anadditional $9.1 million, before income tax, of the amount reported in OCI willbe reclassified into interest expense.

 

**Non-designatedCash Flow Hedges**

 

In connectionwith the Separation Transactions, in November 2006, the Company enteredinto four interest rate swap agreements with an aggregate notional amount of$500 million. Interestrate swap agreements with an aggregate notional amount of $150 million expiredin November 2008 and interest rate swap agreements with a notional amountof $350 million expired in November 2009. These interest rate swap agreements were notdesignated as hedges and, accordingly, the changes in fair value of theseinterest rate swap agreements (which were adjusted quarterly) were recorded innet interest expense in our consolidated statements of earnings. Interest expense includes non-cash incomeof $2.2 million of marked-to-market adjustments related to these interest rateswaps for the three months ended March 31, 2009 with no comparable amountfor the three months ended March 31, 2010. Interest expense includesnon-cash income of $2.4 million and non-cash expense of $0.8 million ofmarked-to-market adjustments related to these interest rate swaps for the sixmonths ended March 31, 2010 and 2009, respectively. Please see the Company’sAnnual Report on Form 10-K for the fiscal year ended September 30,2009 for additional information about these interest rate swap agreements.

 

As a result of the Company’s acquisition of SinelcoGroup NV (“Sinelco”) on December 16, 2009, the Company, through Sinelco,uses foreign currency options to manage the exposure to certain foreigncurrencies in connection with Sinelco’s purchases of merchandise. These foreigncurrency option agreements are not designated as hedges and do not meet thehedge accounting requirements of ASC 815. Accordingly, the changes in fair value of thesederivative instruments (which are adjusted quarterly) are recorded in selling,general and administrative expenses in our consolidated statements of earnings.Selling, general and administrative expenses are net of non-cash income of $0.3 millionof marked-to-market adjustments related to theseforeign currency options for the three and six months ended March 31,2010. Please see Note 9 forinformation about the acquisition of Sinelco.

 

19

----

Table of Contents

 

Sally Holdings LLC and Subsidiaries

Condensed Notes to Consolidated Financial Statements

(Unaudited)

 

Thetable below presents the fair value of the Company’s derivative financialinstruments as well as their classification on the balance sheet as of March 31,2010 (in thousands):

 

**TabularDisclosure of Fair Values of Derivative Instruments**

 
| ** **                                               | ** ** | **Asset  Derivatives**         | ** ** | **Liability  Derivatives**     | ** ** |
|----------------------------------------------------------|------------|--------------------------------|------------|--------------------------------|------------|
| ** **                                               | ** ** | **As of  March 31, 2010** | ** ** | **As of  March 31, 2010** | ** ** |
| ** **                                               | ** ** | **Balance Sheet  Location**    | ** ** | **Fair Value**                 | ** ** | **Balance Sheet  Location** | ** ** | **Fair Value** | ** ** |
| Derivatives designated as  hedging instruments:          |       |                           |       |                           |       |   |   |   |   |
| Interest Rate Swaps                                      |       | Other assets                   |       | $                              | —     |   | Other liabilities |   | $ | 15,104 |   |
| Total derivatives  designated as hedging instruments     |       |                           |       | $                              | —     |   |   |   | $ | 15,104 |   |
|                                                     |       |                           |       |                           |       |   |   |   |   |
| Derivatives not designated  as hedging instruments:      |       |                           |       |                           |       |   |   |   |   |
| Foreign Currency Options                                 |       | Prepaid expenses               |       | $                              | 383        |   | Accrued expenses |   | $ | — |   |
| Interest Rate Swaps                                      |       | Prepaid expenses               |       | —                         |       | Accrued expenses |   | — |   |
| Total derivatives not  designated as hedging instruments |       |                           |       | $                              | 383        |   |   |   | $ | — |   |

 

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

 

**TabularDisclosure of Fair Values of Derivative Instruments**

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

 

20

----

Table of Contents

 

Sally Holdings LLC and Subsidiaries

Condensed Notes to Consolidated Financial Statements

(Unaudited)

 

The tables below presentthe effect of the Company’s derivative financial instruments on the statementsof earnings for the three months ended March 31, 2010 and 2009 (inthousands):

 

**TabularDisclosure of the Effect of Derivative Instruments on the Statement of Earningsfor the**

**ThreeMonths Ended March 31, 2010**

 
| **Derivatives  in Cash  Flow Hedging  Relationships** | ** ** | **Amount of  Gain or  (Loss)  Recognized  in OCI on  Derivative  (Effective  Portion), net  of tax** | ** ** | **Location of Gain or  (Loss) Reclassified from  Accumulated OCI into  Income (Effective  Portion)** | ** **            | **Amount of  Gain or (Loss)  Reclassified  from  Accumulated  OCI into  Income  (Effective  Portion)** | ** ** | **Location of Gain or  (Loss) Recognized in  Income on Derivative  (Ineffective Portion  and Amount  Excluded from  Effectiveness Testing)** | ** ** | **Amount of Gain  or (Loss)  Recognized in  Income on  Derivative  (Ineffective  Portion and  Amount  Excluded from  Effectiveness  Testing)** | ** ** |
|-------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------|-----------------------|--------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| Interest Rate Swaps                                   |       | $                                                                                                    | (673       | )                                                                                                    | Interest expense, net |                                                                                                   | $          | (2,511                                                                                                                                       | )          | Interest expense, net                                                                                                                          |       | $ | — |   |
|                                                       |            |                                                                                                      |            |                                                                                                      |                       |                                                                                                        |            |                                                                                                                                              |            |                                                                                                                                                |            |  |  |  |

 
| **Derivatives  Not Designated as Hedging  Instruments**  | ** ** | **Location of Gain or  (Loss) Recognized in  Income on Derivative** | ** ** | **Amount of  Gain or (Loss)  Recognized in  Income on  Derivative** | ** ** |
|----------------------------------------------------------|------------|---------------------------------------------------------------------|------------|---------------------------------------------------------------------|------------|
| Foreign Currency Options                                 |       | Selling, general and administrative expenses                        |       | 261                                                                 |       |
| Interest Rate Swaps                                      |       | Interest expense, net                                               |       | $                                                                   | —     |   |
| Total derivatives not  designated as hedging instruments |       |                                                                |       | $                                                                   | 261        |   |

** **

 

**TabularDisclosure of the Effect of Derivative Instruments on the Statement of Earningsfor the**

**ThreeMonths Ended March 31, 2009**

 
| **Derivatives  in Cash  Flow Hedging  Relationships** | ** ** | **Amount of  Gain or  (Loss)  Recognized  in OCI on  Derivative  (Effective  Portion), net  of tax** | ** ** | **Location of Gain or  (Loss) Reclassified  from Accumulated  OCI into Income  (Effective Portion)** | ** **            | **Amount of  Gain or (Loss)  Reclassified  from  Accumulated  OCI into  Income  (Effective  Portion)** | ** ** | **Location of Gain or  (Loss) Recognized in  Income on Derivative  (Ineffective Portion  and Amount Excluded  from Effectiveness  Testing)** | ** ** | **Amount of Gain  or (Loss)  Recognized in  Income on  Derivative  (Ineffective  Portion and  Amount Excluded  from  Effectiveness  Testing)** | ** ** |
|-------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------|-----------------------|--------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| Interest Rate Swaps                                   |       | $                                                                                                    | (1,336     | )                                                                                                    | Interest expense, net |                                                                                                   | $          | (2,345                                                                                                                                       | )          | Interest expense, net                                                                                                                          |       | $ | — |   |
|                                                       |            |                                                                                                      |            |                                                                                                      |                       |                                                                                                        |            |                                                                                                                                              |            |                                                                                                                                                |            |  |  |  |

 
| **Derivatives  Not Designated as Hedging  Instruments** | ** ** | **Location of Gain or   (Loss) Recognized in   Income on Derivative** | ** ** | **Amount of  Gain or (Loss)  Recognized in  Income on  Derivative** | ** ** |
|---------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|---------------------------------------------------------------------|------------|
| Interest Rate Swaps                                     |       | Interest expense, net                                                 |       | $                                                                   | (541       | ) |
|                                                         |            |                                                                       |            |                                                                     |            |  |

 

21

----

Table ofContents

 

Sally Holdings LLC and Subsidiaries

Condensed Notes to Consolidated Financial Statements

(Unaudited)

 

Thetables below present the effect of the Company’s derivative financialinstruments on the statements of earnings for the six months ended March 31,2010 and 2009 (in thousands):

** **

**TabularDisclosure of the Effect of Derivative Instruments on the Statement of Earningsfor the**

**Six MonthsEnded March 31, 2010**

 
| **Derivatives  in Cash  Flow Hedging  Relationships** | ** ** | **Amount of  Gain or  (Loss)  Recognized  in OCI on  Derivative  (Effective  Portion), net  of tax** | ** ** | **Location of Gain or  (Loss) Reclassified from  Accumulated OCI into  Income (Effective  Portion)** | ** **            | **Amount of  Gain or (Loss)  Reclassified  from  Accumulated  OCI into  Income  (Effective  Portion)** | ** ** | **Location of Gain or  (Loss) Recognized in  Income on Derivative  (Ineffective Portion  and Amount  Excluded from  Effectiveness Testing)** | ** ** | **Amount of Gain  or (Loss)  Recognized in  Income on  Derivative  (Ineffective  Portion and  Amount  Excluded from  Effectiveness  Testing)** | ** ** |
|-------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------|-----------------------|--------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| Interest Rate Swaps                                   |       | $                                                                                                    | 159        |                                                                                                 | Interest expense, net |                                                                                                   | $          | (5,070                                                                                                                                       | )          | Interest expense, net                                                                                                                          |       | $ | — |   |
|                                                       |            |                                                                                                      |            |                                                                                                      |                       |                                                                                                        |            |                                                                                                                                              |            |                                                                                                                                                |            |  |  |  |

 
| **Derivatives  Not Designated as Hedging  Instruments**  | ** ** | **Location of Gain or  (Loss) Recognized in  Income on Derivative** | ** ** | **Amount of  Gain or (Loss)  Recognized in  Income on  Derivative** | ** ** |
|----------------------------------------------------------|------------|---------------------------------------------------------------------|------------|---------------------------------------------------------------------|------------|
| Foreign Currency Options                                 |       | Selling, general and administrative expenses                        |       | 261                                                                 |       |
| Interest Rate Swaps                                      |       | Interest expense, net                                               |       | $                                                                   | (24        | ) |
| Total derivatives not  designated as hedging instruments |       |                                                                |       | $                                                                   | 237        |   |

** **

**TabularDisclosure of the Effect of Derivative Instruments on the Statement of Earningsfor the**

**Six MonthsEnded March 31, 2009**

 
| **Derivatives  in Cash  Flow Hedging  Relationships** | ** ** | **Amount of  Gain or  (Loss)  Recognized  in OCI on  Derivative  (Effective  Portion), net  of tax** | ** ** | **Location of Gain or  (Loss) Reclassified  from Accumulated  OCI into Income  (Effective Portion)** | ** **            | **Amount of  Gain or (Loss) Reclassified  from  Accumulated  OCI into  Income  (Effective  Portion)** | ** ** | **Location of Gain or  (Loss) Recognized in  Income on Derivative  (Ineffective Portion  and Amount Excluded  from Effectiveness  Testing)** | ** ** | **Amount of Gain  or (Loss)  Recognized in  Income on  Derivative  (Ineffective  Portion and  Amount Excluded  from  Effectiveness  Testing)** | ** ** |
|-------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------|-----------------------|-------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| Interest Rate Swaps                                   |       | $                                                                                                    | (12,209    | )                                                                                                    | Interest expense, net |                                                                                                  | $          | (3,013                                                                                                                                       | )          | Interest expense, net                                                                                                                          |       | $ | — |   |
|                                                       |            |                                                                                                      |            |                                                                                                      |                       |                                                                                                       |            |                                                                                                                                              |            |                                                                                                                                                |            |  |  |  |

 
| **Derivatives  Not Designated as Hedging   Instruments** | ** ** | **Location of Gain or  (Loss) Recognized in  Income on Derivative** | ** ** | **Amount of  Gain or (Loss)  Recognized in  Income on  Derivative** | ** ** |
|----------------------------------------------------------|------------|---------------------------------------------------------------------|------------|---------------------------------------------------------------------|------------|
| Interest Rate Swaps                                      |       | Interest expense, net                                               |       | $                                                                   | (6,187     | ) |
|                                                          |            |                                                                     |            |                                                                     |            |  |

 

22

----

Table of Contents

 

Sally Holdings LLC and Subsidiaries

Condensed Notes to Consolidated Financial Statements

(Unaudited)

 

**Credit-risk-relatedContingent Features**

 

The agreements governing the Company’s interest rateswaps contain provisions pursuant to which the Company could be declared indefault on its interest rate swap obligations in the event the Companydefaulted under certain terms of the loan documents governing the Company’s ABLfacility. As of March 31, 2010, the fair value of interest rate swaps in aliability position related to these agreements was $15.1 million. As of March 31,2010, the Company was under no obligation to post and had not posted any collateralrelated to these agreements. If the Company breached any of these provisions,it would be required to settle its obligations under the agreements at theirtermination value of $15.6 million, including accrued interest and othertermination costs.

 

The Company’s foreign operations expose the Company to fluctuations inforeign currency exchange rates and foreign interest rates.  These fluctuations may impact, among otherthings, the amount of the Company’s past and future cash flows in terms of theCompany’s functional currency, the U.S. dollar. As a result of the Company’s acquisition of Sinelco on December 16,2009, the Company, through Sinelco, uses foreign currency options to manage theexposure to certain foreign currencies in connection with Sinelco’s purchasesof merchandise. Please see Note 9 for information aboutthe acquisition of Sinelco.

 

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

 

**8.   Income Taxes**

** **

**Sally Beauty and its subsidiaries, including theCompany, file consolidated income tax returns in the U.S. federal jurisdictionand most state jurisdictions, as well as in various foreign jurisdictions.**

** **

The transactionsseparating us from Alberto-Culver were intended to qualify as a reorganizationunder Section 368(a)(1)(D) of the Internal Revenue Code of 1986, asamended (the “Code”) and a distribution eligible for non-recognition under Sections355(a) and 361(c) of the Code. In connection with the sharedistribution of Alberto-Culver common stock in the Separation Transactions,Sally Beauty received: (i) a private letter ruling from the IRS and (ii) anopinion of Sidley Austin LLP, counsel to Alberto-Culver, in each case, to theeffect that the transactions qualify as a reorganization 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.

 

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

 

In addition, as thesuccessor entity to Alberto-Culver after the Separation Transactions, SallyBeauty relies upon the prior year federal income tax returns of Alberto-Culverand accounting methods established therein for certain calculations that affectSally Beauty’s and the Company’s current consolidated U.S. federal income taxliability.

 

The IRS has initiated anexamination of the Sally Beauty’s consolidated federal income tax returns forthe fiscal years ended September 30, 2008 and 2007. The IRS had previouslyaudited Sally Beauty’s consolidated federal income tax returns through the taxyear ended September 30, 2006, thus the statute remains open from the year

 

23

----

Table ofContents

 

Sally Holdings LLC and Subsidiaries

Condensed Notes to Consolidated Financial Statements

(Unaudited)

 

ended September 30,2007 forward.  Our foreign subsidiariesare impacted by various statutes of limitations, which are generally open from2004 forward. Generally, states’ statutes in the United States are open for taxreviews from 2005 forward.

 

**9.   Acquisitions**

 

On December 16,2009, the Company acquired Sinelco, a wholesale distributor of professionalbeauty products based in Ronse, Belgium, for approximately €25.5 million(approximately $37.1 million). Sinelco serves over 1,500 customers through aproduct catalog and website and has sales throughout Europe. Goodwill of $17.6million was recorded as a result of this acquisition. In addition, during thesix months ended March 31, 2010, the Company completed several otherindividually immaterial acquisitions at an aggregate cost of $5.5 million andrecorded goodwill in the amount of $3.2 million. The valuation of the assetsacquired and liabilities assumed in connection with all acquisitions completedduring the six months ended March 31, 2010 was based on their estimatedfair values at the acquisition date. The final valuation of the assets acquiredand liabilities assumed will be completed during the fiscal year 2010.

 

##### ***10.  BusinessSegments***

##### *** ***

The Company’s business isorganized into two separate segments: (i) Sally Beauty Supply, a domesticand international chain of cash and carry retail stores which offersprofessional beauty supplies to both salon professionals and retail customersand (ii) BSG, including its franchise-based business Armstrong McCall, afull service beauty supply distributor which offers professional brands ofbeauty products directly to salons through its own sales force and professionalonly stores (including franchise stores) in generally exclusive geographical territories inNorth America and parts of Europe.

 

Sales between segments, which were eliminated in consolidation, werenot material during the periods ended March 31, 2010 and 2009.  Segment data for the three and six monthsended March 31, 2010 and 2009 is as follows (in thousands):

 
| ** **                                  | ** ** | **Three  months ended********March 31,** | ** ** | **Six months  ended********March 31,** | ** ** |
|---------------------------------------------|------------|-----------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                  | ** ** | **2010**                                      | ** ** | **2009**                                    | ** ** | **2010** | ** ** | **2009** | ** ** |
| Net sales:                                  |       |                                          |       |                                        |       |   |   |   |   |
| Sally Beauty Supply                         |       | $                                             | 453,634    |                                        | $          | 412,338 |   | $ | 891,949 |   | $ | 822,875 |   |
| BSG                                         |       | 266,833                                       |       | 229,173                                     |       | 533,369 |   | 464,212 |   |
| Total net sales                             |       | $                                             | 720,467    |                                        | $          | 641,511 |   | $ | 1,425,318 |   | $ | 1,287,087 |   |
| Earnings before provision for income taxes: |       |                                          |       |                                        |       |   |   |   |   |
| Segment operating profit:                   |       |                                          |       |                                        |       |   |   |   |   |
| Sally Beauty Supply                         |       | $                                             | 79,520     |                                        | $          | 70,379 |   | $ | 150,626 |   | $ | 135,665 |   |
| BSG                                         |       | 26,027                                        |       | 20,359                                      |       | 51,624 |   | 40,595 |   |
| Total segment operating profit              |       | 105,547                                       |       | 90,738                                      |       | 202,250 |   | 176,260 |   |
| Unallocated corporate expenses (a)          |       | (16,947                                       | )          | (15,147                                     | )          | (36,242 | ) | (28,941 | ) |
| Share-based compensation expense            |       | (2,231                                        | )          | (1,424                                      | )          | (7,054 | ) | (4,892 | ) |
| Interest expense, net                       |       | (28,414                                       | )          | (31,958                                     | )          | (56,865 | ) | (71,631 | ) |
| Earnings before provision for income taxes  |       | $                                             | 57,955     |                                        | $          | 42,209 |   | $ | 102,089 |   | $ | 70,796 |   |

 

----

(a)   Unallocated expenses consist of corporate andshared costs.

 

24

----

Table ofContents

 

Sally Holdings LLC and Subsidiaries

Condensed Notes to Consolidated Financial Statements

(Unaudited)

 

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

##  

The following condensedconsolidating financial information presents the Condensed Consolidated BalanceSheets as of March 31, 2010 and September 30, 2009, the CondensedConsolidated Statements of Earnings for the three and six months ended March 31,2010 and 2009, and the Condensed Consolidated Statements of Cash Flows for thesix months ended March 31, 2010 and 2009 of: (i) Sally Holdings, or “theParent;” (ii) the guarantor subsidiaries; (iii) the non-guarantorsubsidiaries; (iv) elimination entries necessary to consolidate the Parentwith the guarantor and non-guarantor subsidiaries; and (v) the Parent on aconsolidated basis.

 

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

 

25

----

Table of Contents

 

Sally Holdings LLC and Subsidiaries

Condensed Notes to Consolidated Financial Statements

(Unaudited)

 

**SALLYHOLDINGS LLC AND SUBSIDIARIES**

CondensedConsolidating Balance Sheet

March 31,2010

(In thousands)

 
| ** **                                                                  | ** ** | **Parent** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-  Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Sally  Holdings  LLC &  Subsidiaries** | ** ** |
|-----------------------------------------------------------------------------|------------|------------|------------|-----------------------------|------------|-----------------------------------|------------|------------------|------------|---------------------------------------------------|------------|
| **Assets**                                                                  |       |       |       |                        |       |                              |       |             |       |                                              |       |
| Cash and cash equivalents                                                   |       | $          | 325        |                        | $          | 14,516                            |       | $                | 22,579     |                                              | $          | — |   | $ | 37,420 |   |
| Trade accounts and other  receivables, less allowance for doubtful accounts |       | —     |       | 55,261                      |       | 25,391                            |       | —           |       | 80,652                                            |       |
| Due from affiliates                                                         |       | —     |       | 424,119                     |       | 4,911                             |       | (429,030         | )          | —                                            |       |
| Inventories                                                                 |       | —     |       | 448,813                     |       | 130,140                           |       | —           |       | 578,953                                           |       |
| Prepaid expenses                                                            |       | 145        |       | 11,884                      |       | 7,917                             |       | —           |       | 19,946                                            |       |
| Deferred income tax assets                                                  |       | 929        |       | 18,016                      |       | (3,213                            | )          | —           |       | 15,732                                            |       |
| Property and equipment, net                                                 |       | —     |       | 115,658                     |       | 49,235                            |       | —           |       | 164,893                                           |       |
| Investment in subsidiaries                                                  |       | 1,460,609  |       | 306,168                     |       | —                            |       | (1,766,777       | )          | —                                            |       |
| Goodwill and other  intangible assets, net                                  |       | —     |       | 427,152                     |       | 158,752                           |       | —           |       | 585,904                                           |       |
| Other assets                                                                |       | 29,032     |       | 12,655                      |       | 4,626                             |       | —           |       | 46,313                                            |       |
| Total assets                                                                |       | $          | 1,491,040  |                        | $          | 1,834,242                         |       | $                | 400,338    |                                              | $          | (2,195,807 | ) | $ | 1,529,813 |   |
|                                                                        |       |       |       |                        |       |                              |       |             |       |                                              |       |
| **Liabilities and Member’s  (Deficit) Equity**                         |       |       |       |                        |       |                              |       |             |       |                                              |       |
| Accounts payable                                                            |       | $          | 305        |                        | $          | 160,020                           |       | $                | 42,498     |                                              | $          | — |   | $ | 202,823 |   |
| Due to affiliates                                                           |       | 412,354    |       | 4,911                       |       | 11,765                            |       | (429,030         | )          | —                                            |       |
| Accrued expenses                                                            |       | 26,075     |       | 109,268                     |       | 23,251                            |       | —           |       | 158,594                                           |       |
| Due to Sally Beauty                                                         |       | —     |       | 28,127                      |       | —                            |       | —           |       | 28,127                                            |       |
| Income taxes                                                                |       | 4,376      |       | 1,791                       |       | (2,089                            | )          | —           |       | 4,078                                             |       |
| Long-term debt                                                              |       | 1,623,572  |       | 129                         |       | 15,386                            |       | —           |       | 1,639,087                                         |       |
| Other liabilities                                                           |       | 15,104     |       | 27,868                      |       | 1,055                             |       | —           |       | 44,027                                            |       |
| Deferred income tax  liabilities                                            |       | (6,066     | )          | 41,519                      |       | 2,304                             |       | —           |       | 37,757                                            |       |
| Total liabilities                                                           |       | 2,075,720  |       | 373,633                     |       | 94,170                            |       | (429,030         | )          | 2,114,493                                         |       |
| Stock options subject to  redemption                                        |       | 1,763      |       | —                      |       | —                            |       | —           |       | 1,763                                             |       |
| Total member’s (deficit)  equity                                       |       | (586,443   | )          | 1,460,609                   |       | 306,168                           |       | (1,766,777       | )          | (586,443                                          | )          |
| Total liabilities and  member’s (deficit) equity                       |       | $          | 1,491,040  |                        | $          | 1,834,242                         |       | $                | 400,338    |                                              | $          | (2,195,807 | ) | $ | 1,529,813 |   |

 

26

----

Table of Contents

 

Sally Holdings LLC and Subsidiaries

Condensed Notes to Consolidated Financial Statements

(Unaudited)

 

**SALLYHOLDINGS LLC AND SUBSIDIARIES**

CondensedConsolidating Balance Sheet

September 30,2009

(In thousands)

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

 

27

----

Table ofContents

 

Sally Holdings LLC and Subsidiaries

Condensed Notes to Consolidated Financial Statements

(Unaudited)

 

**SALLY HOLDINGS LLC AND SUBSIDIARIES**

Condensed Consolidating Statement of EarningsThree months ended March 31, 2010

(In thousands)

** **
| ** **                                           | ** ** | **Parent** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-  Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Sally Holdings  LLC&  Subsidiaries** | ** ** |
|------------------------------------------------------|------------|------------|------------|-----------------------------|------------|-----------------------------------|------------|------------------|------------|--------------------------------------------|------------|
| ** **                                           | ** ** | ** ** | ** ** | ** **                  | ** ** | ** **                        | ** ** | ** **       | ** ** | ** **                                 | ** ** |
| Net sales                                            |       | $          | —     |                        | $          | 589,409                           |       | $                | 131,058    |                                       | $          | — |   | $ | 720,467 |   |
| Related party sales                                  |       | —     |       | 659                         |       | —                            |       | (659             | )          | —                                     |       |
| Cost of products sold and  distribution expenses     |       | —     |       | 303,735                     |       | 73,107                            |       | (659             | )          | 376,183                                    |       |
| Gross profit                                         |       | —     |       | 286,333                     |       | 57,951                            |       | —           |       | 344,284                                    |       |
| Selling, general and  administrative expenses        |       | 141        |       | 192,088                     |       | 53,256                            |       | —           |       | 245,485                                    |       |
| Depreciation and  amortization                       |       | —     |       | 9,038                       |       | 3,392                             |       | —           |       | 12,430                                     |       |
| Operating earnings (loss)                            |       | (141       | )          | 85,207                      |       | 1,303                             |       | —           |       | 86,369                                     |       |
| Interest income                                      |       |       |       | (15                         | )          | (41                               | )          | —           |       | (56                                        | )          |
| Interest expense                                     |       | 28,222     |       | 17                          |       | 231                               |       | —           |       | 28,470                                     |       |
| Earnings (losses) before  provision for income taxes |       | (28,363    | )          | 85,205                      |       | 1,113                             |       | —           |       | 57,955                                     |       |
| Provision (benefit) for  income taxes                |       | (9,975     | )          | 31,333                      |       | 731                               |       | —           |       | 22,089                                     |       |
| Equity in earnings of  subsidiaries (net of tax)     |       | 54,254     |       | 382                         |       | —                            |       | (54,636          | )          | —                                     |       |
| Net earnings                                         |       | $          | 35,866     |                        | $          | 54,254                            |       | $                | 382        |                                       | $          | (54,636 | ) | $ | 35,866 |   |

 

28

----

Table ofContents

 

Sally Holdings LLC and Subsidiaries

Condensed Notes to Consolidated Financial Statements

(Unaudited)

 

**SALLY HOLDINGS LLC AND SUBSIDIARIES**

Condensed Consolidating Statement of EarningsThree months ended March 31, 2009

 (In thousands)

** **
| ** **                                           | ** ** | **Parent** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-  Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Sally Holdings  LLC&  Subsidiaries** | ** ** |
|------------------------------------------------------|------------|------------|------------|-----------------------------|------------|-----------------------------------|------------|------------------|------------|--------------------------------------------|------------|
| ** **                                           | ** ** | ** ** | ** ** | ** **                  | ** ** | ** **                        | ** ** | ** **       | ** ** | ** **                                 | ** ** |
| Net sales                                            |       | $          | —     |                        | $          | 538,932                           |       | $                | 102,579    |                                       | $          | — |   | $ | 641,511 |   |
| Related party sales                                  |       | —     |       | 663                         |       | —                            |       | (663             | )          | —                                     |       |
| Cost of products sold and  distribution expenses     |       | —     |       | 282,300                     |       | 57,762                            |       | (663             | )          | 339,399                                    |       |
| Gross profit                                         |       | —     |       | 257,295                     |       | 44,817                            |       | —           |       | 302,112                                    |       |
| Selling, general and  administrative expenses        |       | 134        |       | 172,761                     |       | 43,579                            |       | —           |       | 216,474                                    |       |
| Depreciation and  amortization                       |       | —     |       | 8,697                       |       | 2,774                             |       | —           |       | 11,471                                     |       |
| Operating earnings (loss)                            |       | (134       | )          | 75,837                      |       | (1,536                            | )          | —           |       | 74,167                                     |       |
| Interest income                                      |       |       |       | (49                         | )          | (7                                | )          | —           |       | (56                                        | )          |
| Interest expense                                     |       | 31,865     |       | 85                          |       | 64                                |       | —           |       | 32,014                                     |       |
| Earnings (losses) before  provision for income taxes |       | (31,999    | )          | 75,801                      |       | (1,593                            | )          | —           |       | 42,209                                     |       |
| Provision (benefit) for  income taxes                |       | (13,417    | )          | 31,670                      |       | (1,783                            | )          | —           |       | 16,470                                     |       |
| Equity in earnings of  subsidiaries (net of tax)     |       | 44,321     |       | 190                         |       | —                            |       | (44,511          | )          | —                                     |       |
| Net earnings                                         |       | $          | 25,739     |                        | $          | 44,321                            |       | $                | 190        |                                       | $          | (44,511 | ) | $ | 25,739 |   |

 

29

----

Table ofContents

 

Sally Holdings LLC and Subsidiaries

Condensed Notes to Consolidated Financial Statements

(Unaudited)

 

**SALLY HOLDINGS LLC AND SUBSIDIARIES**

Condensed Consolidating Statement of EarningsSix months ended March 31, 2010

(In thousands)

** **
| ** **                                           | ** ** | **Parent** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-  Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Sally Holdings  LLC &  Subsidiaries** | ** ** |
|------------------------------------------------------|------------|------------|------------|-----------------------------|------------|-----------------------------------|------------|------------------|------------|--------------------------------------------------|------------|
| ** **                                           | ** ** | ** ** | ** ** | ** **                  | ** ** | ** **                        | ** ** | ** **       | ** ** | ** **                                       | ** ** |
| Net sales                                            |       | $          | —     |                        | $          | 1,159,360                         |       | $                | 265,958    |                                             | $          | — |   | $ | 1,425,318 |   |
| Related party sales                                  |       | —     |       | 1,474                       |       | —                            |       | (1,474           | )          | —                                           |       |
| Cost of products sold and  distribution expenses     |       | —     |       | 602,036                     |       | 147,257                           |       | (1,474           | )          | 747,819                                          |       |
| Gross profit                                         |       | —     |       | 558,798                     |       | 118,701                           |       | —           |       | 677,499                                          |       |
| Selling, general and  administrative expenses        |       | 329        |       | 387,496                     |       | 106,401                           |       | —           |       | 494,226                                          |       |
| Depreciation and  amortization                       |       |       |       | 17,901                      |       | 6,418                             |       | —           |       | 24,319                                           |       |
| Operating earnings (loss)                            |       | (329       | )          | 153,401                     |       | 5,882                             |       | —           |       | 158,954                                          |       |
| Interest income                                      |       | —     |       | (33                         | )          | (42                               | )          | —           |       | (75                                              | )          |
| Interest expense                                     |       | 56,485     |       | 61                          |       | 394                               |       | —           |       | 56,940                                           |       |
| Earnings (losses) before  provision for income taxes |       | (56,814    | )          | 153,373                     |       | 5,530                             |       | —           |       | 102,089                                          |       |
| Provision (benefit) for  income taxes                |       | (21,391    | )          | 58,315                      |       | 1,937                             |       | —           |       | 38,861                                           |       |
| Equity in earnings of  subsidiaries (net of tax)     |       | 98,651     |       | 3,593                       |       | —                            |       | (102,244         | )          | —                                           |       |
| Net earnings                                         |       | $          | 63,228     |                        | $          | 98,651                            |       | $                | 3,593      |                                             | $          | (102,244 | ) | $ | 63,228 |   |

 

30

----

Table ofContents

 

Sally Holdings LLC and Subsidiaries

Condensed Notes to Consolidated Financial Statements

(Unaudited)

 

**SALLY HOLDINGS LLC AND SUBSIDIARIES**

Condensed Consolidating Statement of EarningsSix months ended March 31, 2009

(In thousands)

 
| ** **                                           | ** ** | **Parent** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-  Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Sally Holdings  LLC &  Subsidiaries** | ** ** |
|------------------------------------------------------|------------|------------|------------|-----------------------------|------------|-----------------------------------|------------|------------------|------------|--------------------------------------------------|------------|
| ** **                                           | ** ** | ** ** | ** ** | ** **                  | ** ** | ** **                        | ** ** | ** **       | ** ** | ** **                                       | ** ** |
| Net sales                                            |       | $          | —     |                        | $          | 1,065,376                         |       | $                | 221,711    |                                             | $          | — |   | $ | 1,287,087 |   |
| Related party sales                                  |       | —     |       | 1,440                       |       | —                            |       | (1,440           | )          | —                                           |       |
| Cost of products sold and  distribution expenses     |       | —     |       | 557,856                     |       | 125,015                           |       | (1,440           | )          | 681,431                                          |       |
| Gross profit                                         |       | —     |       | 508,960                     |       | 96,696                            |       | —           |       | 605,656                                          |       |
| Selling, general and  administrative expenses        |       | 343        |       | 349,414                     |       | 90,254                            |       | —           |       | 440,011                                          |       |
| Depreciation and  amortization                       |       |       |       | 17,736                      |       | 5,482                             |       | —           |       | 23,218                                           |       |
| Operating earnings (loss)                            |       | (343       | )          | 141,810                     |       | 960                               |       | —           |       | 142,427                                          |       |
| Interest income                                      |       | —     |       | (111                        | )          | (93                               | )          | —           |       | (204                                             | )          |
| Interest expense                                     |       | 71,512     |       | 153                         |       | 170                               |       | —           |       | 71,835                                           |       |
| Earnings (losses) before  provision for income taxes |       | (71,855    | )          | 141,768                     |       | 883                               |       | —           |       | 70,796                                           |       |
| Provision (benefit) for  income taxes                |       | (30,146    | )          | 59,201                      |       | (1,205                            | )          | —           |       | 27,850                                           |       |
| Equity in earnings of  subsidiaries (net of tax)     |       | 84,655     |       | 2,088                       |       | —                            |       | (86,743          | )          | —                                           |       |
| Net earnings                                         |       | $          | 42,946     |                        | $          | 84,655                            |       | $                | 2,088      |                                             | $          | (86,743 | ) | $ | 42,946 |   |

 

31

----

Table ofContents

 

Sally Holdings LLC and Subsidiaries

Condensed Notes to Consolidated Financial Statements

(Unaudited)

 

**SALLY HOLDINGS LLC AND SUBSIDIARIES**

Condensed Consolidating Statement of Cash FlowsSix months ended March 31, 2010

(In thousands)

 
| ** **                                                                 | ** ** | ** ** | ** ** | **Guarantor**    | ** ** | **Non-  Guarantor** | ** ** | ** **       | ** ** | **Sally Holdings  LLC** | ** ** |
|----------------------------------------------------------------------------|------------|------------|------------|------------------|------------|---------------------|------------|------------------|------------|-------------------------|------------|
| ** **                                                                 | ** ** | **Parent** | ** ** | **Subsidiaries** | ** ** | **Subsidiaries**    | ** ** | **Eliminations** | ** ** | **& Subsidiaries**  | ** ** |
| **Net  cash provided (used) by operating activities**                      | ** ** | $          | 50,285     |             | $          | (4,168              | )          | $                | 46,819     |                    | $          | — |   | $ | 92,936 |   |
| ** **                                                                 | ** ** |       |       |             |       |                |       |             |       |                    |       |
| **Cash Flows  from Investing Activities:**                                 |       |       |       |             |       |                |       |             |       |                    |       |
| Capital expenditures, net  of proceeds from sale of property and equipment |       | —     |       | (15,037          | )          | (8,071              | )          | —           |       | (23,108                 | )          |
| Acquisitions, net of cash  acquired                                        |       | —     |       | (3,835           | )          | (31,101             | )          | —           |       | (34,936                 | )          |
| Net cash used by investing  activities                                     |       | —     |       | (18,872          | )          | (39,172             | )          | —           |       | (58,044                 | )          |
|                                                                       |       |       |       |             |       |                |       |             |       |                    |       |
| **Cash Flows  from Financing Activities:**                                 |       |       |       |             |       |                |       |             |       |                    |       |
| Change in book cash  overdraft                                             |       | 305        |       | —           |       | —              |       | —           |       | 305                     |       |
| Proceeds from issuance of  long-term debt                                  |       | 219,000    |       | —           |       | —              |       | —           |       | 219,000                 |       |
| Repayments of long-term  debt                                              |       | (269,285   | )          | (62              | )          | (1,171              | )          | —           |       | (270,518                | )          |
| Excess tax benefit from  share-based compensation                          |       | —     |       | 25               |       | —              |       | —           |       | 25                      |       |
| Net cash used by financing  activities                                     |       | (49,980    | )          | (37              | )          | (1,171              | )          | —           |       | (51,188                 | )          |
| Effect of foreign exchange  rate changes on cash and cash equivalents      |       | —     |       | —           |       | (731                | )          | —           |       | (731                    | )          |
|                                                                       |       |       |       |             |       |                |       |             |       |                    |       |
| Net increase (decrease) in  cash and cash equivalents                      |       | 305        |       | (23,077          | )          | 5,745               |       | —           |       | (17,027                 | )          |
| Cash and cash equivalents,  beginning of period                            |       | 20         |       | 37,593           |       | 16,834              |       | —           |       | 54,447                  |       |
| Cash and cash equivalents,  end of period                                  |       | $          | 325        |             | $          | 14,516              |       | $                | 22,579     |                    | $          | — |   | $ | 37,420 |   |

 

32

----

Table ofContents

 

Sally Holdings LLC and Subsidiaries

Condensed Notes to Consolidated Financial Statements

(Unaudited)

 

**SALLY HOLDINGS LLC AND SUBSIDIARIES**

Condensed Consolidated Statement of Cash FlowsSix months ended March 31, 2009

(In thousands)

** **
| ** **                                                                 | ** ** | ** ** | ** ** | **Guarantor**    | ** ** | **Non-  Guarantor** | ** ** | ** **       | ** ** | **Sally Holdings  LLC** | ** ** |
|----------------------------------------------------------------------------|------------|------------|------------|------------------|------------|---------------------|------------|------------------|------------|-------------------------|------------|
| ** **                                                                 | ** ** | **Parent** | ** ** | **Subsidiaries** | ** ** | **Subsidiaries**    | ** ** | **Eliminations** | ** ** | **& Subsidiaries**  | ** ** |
| **Net cash  provided by operating activities**                             |       | $          | 97,753     |             | $          | 16,966              |       | $                | 9,865      |                    | $          | — |   | $ | 124,584 |   |
| ** **                                                                 |       |       |       |             |       |                |       |             |       |                    |       |
| **Cash Flows  from Investing Activities:**                                 |       |       |       |             |       |                |       |             |       |                    |       |
| Capital expenditures, net  of proceeds from sale of property and equipment |       | —     |       | (11,829          | )          | (4,894              | )          | —           |       | (16,723                 | )          |
| Acquisitions, net of cash  acquired                                        |       | —     |       | (1,280           | )          | (707                | )          | —           |       | (1,987                  | )          |
| Net cash used by investing  activities                                     |       | —     |       | (13,109          | )          | (5,601              | )          | —           |       | (18,710                 | )          |
|                                                                       |       |       |       |             |       |                |       |             |       |                    |       |
| **Cash Flows  from Financing Activities:**                                 |       |       |       |             |       |                |       |             |       |                    |       |
| Change in book cash  overdraft                                             |       | (1,633     | )          | —           |       | —              |       | —           |       | (1,633                  | )          |
| Proceeds from issuance of  long-term debt                                  |       | 94,639     |       | —           |       | —              |       | —           |       | 94,639                  |       |
| Repayments of long-term  debt                                              |       | (192,385   | )          | (114             | )          | (496                | )          | —           |       | (192,995                | )          |
| Excess tax shortfall from  share-based compensation                        |       | —     |       | (226             | )          | —              |       | —           |       | (226                    | )          |
| Net cash used by financing  activities                                     |       | (99,379    | )          | (340             | )          | (496                | )          | —           |       | (100,215                | )          |
| Effect of foreign exchange  rate changes on cash and cash equivalents      |       | —     |       | —           |       | (769                | )          | —           |       | (769                    | )          |
| Net (decrease) increase in  cash and cash equivalents                      |       | (1,626     | )          | 3,517            |       | 2,999               |       | —           |       | 4,890                   |       |
| Cash and cash equivalents,  beginning of period                            |       | 1,645      |       | 85,384           |       | 12,759              |       | —           |       | 99,788                  |       |
| Cash and cash equivalents,  end of period                                  |       | $          | 19         |             | $          | 88,901              |       | $                | 15,758     |                    | $          | — |   | $ | 104,678 |   |

 

33

----

Table of Contents

 

**Item2.  Management’s Discussion and Analysisof Financial Condition and Results of Operations.**

 

This section discusses management’s view of thefinancial condition, results of operations and cash flows of Sally Holdings andits consolidated subsidiaries. All of the interests of Sally Holdings arebeneficially owned by Sally Investment, and all of the interests of SallyInvestment are beneficially owned by Sally Beauty.This section should be read in conjunction with theaudited consolidated financial statements and the related notes included in ourAnnual Report on Form 10-K for the fiscal year ended September 30,2009, as well as the Risk Factors section contained in that Annual Report, andinformation contained elsewhere in this Quarterly Report, including theconsolidated interim financial statements and condensed notes to thosestatements. This Management’s Discussion and Analysis of Financial Conditionand Results of Operations section may contain forward-looking statements. See “CautionaryNotice Regarding Forward-Looking Statements,” included at the beginning of thisQuarterly Report for a discussion of the uncertainties, risks and assumptionsassociated with these forward-looking statements that could cause results todiffer materially from those reflected in such forward-looking statements.

 

**HighlightsFor the First Six Months of Fiscal Year 2010:**

 

·                  Our consolidated same store sales increased by 4.3% for the six monthsended March 31, 2010;

·                  Our consolidated net sales for the six months ended March 31,2010, increased by $138.2 million, or 10.7%, to $1,425.3 million compared to$1,287.1 million for the six months ended March 31, 2009;

·                  Net sales reported for the six months ended March 31, 2010,reflect approximately $20.7 million, or 1.5%, in positive impact from changesin foreign exchange rates;

·                  Our consolidated gross profit for the six months ended March 31,2010, increased $71.8 million, or 11.9%, to $677.5 million compared to $605.7million for the six months ended March 31, 2009. As a percentage of netsales, gross profit increased 40 basis points to 47.5% for the six months endedMarch 31, 2010 compared to 47.1% for the six months ended March 31,2009;

·                  Our consolidated operating earnings for the six months ended March 31,2010, increased $16.5 million, or 11.6%, to $159.0 million compared to $142.4million for the six months ended March 31, 2009;

·                  Net earnings increased $20.3 million, or 47.2%, to $63.2 million forthe six months ended March 31, 2010 compared to $42.9 million for the sixmonths ended March 31, 2009;

·                  Cash provided by operations decreased by $31.6 million to$92.9 million for the six months ended March 31, 2010 compared to$124.6 million for the six months ended March 31, 2009; and

·                  On December 16, 2009, we acquired Sinelco Group NV (“Sinelco”), awholesale distributor of professional beauty products based in Ronse, Belgium,for approximately €25.5 million (approximately $37.1 million).

 

**Overview**

 

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

##### *** ***

We are the largestdistributor of professional beauty supplies in the U.S. based on store count.We operate primarily through two business units, Sally Beauty Supply and BSG.Through Sally Beauty Supply and BSG (which operates stores under the CosmoProfservice mark), we operated a multi-channel platform of 3,768 stores andsupplied 185 franchised stores in North America, South America and selectedEuropean countries, as of March 31, 2010. Within BSG, we also have one ofthe largest networks of professional distributor sales consultants in NorthAmerica, with approximately 1,106 professional distributor sales consultantswho sell directly to salons and salon professionals.  We provide our customers with a wide varietyof leading third-party branded and exclusive-label professional beautysupplies, including hair care products, styling appliances, skin and nail careproducts and other beauty items. Sally Beauty Supply stores target retailconsumers and salon professionals while BSG exclusively targets salons andsalon professionals. For the six months ended March 31, 2010, our netsales and operating earnings were $1,425.3 million and $159.0 million,respectively.

 

We believe Sally BeautySupply is the largest open-line distributor of professional beauty supplies inthe U.S. based on store count. As of March 31, 2010, Sally BeautySupply operated 2,920 company-operated retail stores, 2,367 of which arelocated in the U.S. (with the remainder in the United Kingdom and certain othercountries in Europe, Canada, Puerto Rico, Mexico and Chile) and supplied 26 franchisedstores (all outside the U.S.). Sally Beauty Supply stores in the U.S. range insize between 1,200 square feet and 1,700 square feet and areprimarily located in strip shopping centers. The product selection in SallyBeauty Supply stores ranges between 4,000 and 8,000 SKUs of beauty products andincludes products for hair care, skin and nail care, beauty sundries andelectrical appliances targeting retail consumers and salon professionals. SallyBeauty Supply stores carry leading third-party brands such as Clairol, Revlonand Conair, as well as an extensive selection of exclusive-label merchandise.

 

34

----

Table ofContents

 

We believe BSG is thelargest full-service distributor of professional beauty supplies in theU.S. As of March 31, 2010, BSG had 848 company-operated stores,supplied 159 franchised stores and had a sales force of approximately 1,106professional distributor sales consultants selling exclusively to salons andsalon professionals in substantially all states in the U.S. and inportions of Canada, Puerto Rico, Mexico and certain European countries. BSGstores average approximately 2,700 square feet and are primarily locatedin secondary 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 9,000 SKUs of beauty products, includes hair care and color, skin andnail care, beauty sundries and electrical appliances and targets salons andsalon professionals. BSG carries leading professional beauty product brandsintended for use in salons and for resale by the salon to consumers. CertainBSG products are sold under exclusive distribution agreements with supplierswhereby BSG is designated as the sole distributor for a product line withincertain geographic territories.

 

##### ***Industry and Business Trends***

##### *** ***

We operate within thelarge and growing U.S. professional beauty supply industry. Potentialgrowth in the industry is expected to be driven by increases in hair color,hair loss prevention and hair styling products, accompanied by declines insales of electrical products during periods of prolonged economic slowdown. Webelieve the following key industry and business trends and characteristics willinfluence our business and our financial results going forward:

 

·                  *High level of marketplacefragmentation.*  TheU.S. salon channel is highly fragmented with over 250,000salons. Given the fragmented and small-scale nature of the salon industry,we believe that salon operators will continue to depend on full-service/exclusivedistributors and open-line channels for a majority of their beauty supplypurchases.

 

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

 

·                  *Increasing use ofexclusive-label products.*  Weoffer a broad range of private label and control label products, which wegenerally refer to collectively as “exclusive-label products.” Private labelproducts are brands for which we own or license the trademark and, in someinstances, the formula. Control label products are brands that are owned by themanufacturer, but for which we have been granted sole distribution rights.Generally, our exclusive-label products have higher gross margins than theleading third-party branded products, and we believe this area offers potentialgrowth. Please see “Risk Factors - We depend upon manufacturers who may beunable to provide products of adequate quality or who may be unwilling tocontinue to supply products to us” in Item 1A of our Annual Report on Form 10-Kfor the fiscal year ended September 30, 2009.

 

·                  *Favorable demographic and consumer trends.*  Theaging baby-boomer population is expected to drive future growth in professionalbeauty supply sales through an increase in the usage of hair color and hairloss products. Additionally, continuously changing fashion-related trends thatdrive new hair styles are expected to result in continued demand for hairstyling products. Changes in consumer tastes and fashion trends can have animpact on our financial performance. Our continued success depends in largepart on our ability to anticipate, gauge and react in a timely and effectivemanner to changes in consumer spending patterns and preferences for beautyproducts. We continuously adapt our marketing and merchandising initiatives forSally Beauty Supply in an effort to expand our market reach or to respond tochanging consumer preferences.  If we areunable to anticipate and respond to trends in the marketplace for beautyproducts and changing consumer demands, our business could suffer.

 

·                  *International growthstrategies. *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. For example, on December 16, 2009, we acquired Sinelco Group NV (“Sinelco”), awholesale distributor of professional beauty products with sales throughoutEurope. In addition, on September 4, 2009, we acquiredDistribuidora Intersalon Limitada, a leading distributor of premier beautysupply products with 16 stores located in Chile.  These acquisitions furtheredour expansion plans in Europe and Latin America, key targets of Sally BeautySupply’s international growth initiative. We intend to continue to identify and evaluate 

 

35

----

Table of Contents

 

non-U.S. acquisition targets.  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 economic risks” in Item 1A of our AnnualReport on Form 10-K for the fiscal year ended September 30, 2009.

 

·                  *Continuing consolidation.*  There is continuing consolidationamong professional beauty product distributors and professional beauty productmanufacturers. We plan to continue to examine ways in which we can benefit fromthis trend, including reviewing opportunities to shift business fromcompetitive distributors to the BSG network as well as seeking opportunistic,value-added acquisitions which complement our long-term growth strategy. 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 competes with BSGin certain geographic areas. If L’Oreal acquired other distributors orsuppliers that conduct significant business with BSG, we could lose relatedrevenue. There can be no assurance that there will not be further loss ofrevenue over time by BSG (including within its franchise-based business) due topotential losses of additional products (both from L’Oreal and from othersuppliers) as well as from the increased competition from L’Oreal-affiliateddistribution networks. Please see “Risk Factors - The beauty productsdistribution industry is highly competitive and is consolidating” and “Wedepend upon manufacturers who may be unable to provide products of adequatequality or who may be unwilling to continue to supply products to us” in Item1A of our Annual Report on Form 10-K for the fiscal year ended September 30,2009.

 

·                  *Relationships with suppliers.*  Sally Beauty Supply/BSG and their suppliers are dependent on each other for thedistribution of beauty products. We donot manufacture the brand name or exclusive-label products we sell. We purchaseour products from a limited number of manufacturers. As is typical indistribution businesses, these relationships are subject to change from time totime (including the expansion or loss of distribution rights in variousgeographies and the addition or loss of product lines). Since we purchaseproducts from many manufacturers on an at-will basis, under contracts which cangenerally be terminated without cause upon 90 days’ notice or less orwhich expire without express rights of renewal, such manufacturers coulddiscontinue sales to us at any time or upon the expiration of the distributionperiod. Some of our contracts with manufacturers may be terminated by suchmanufacturers if we fail to meet specified minimum purchase requirements. Insuch cases, we do not have contractual assurances of continued supply, pricingor access to new products and vendors may change the terms upon which theysell. Infrequently, a supplier will seek to terminate a distributionrelationship through legal action. Changes in our relationships with suppliersoccur often and could positively or negatively impact our net sales andoperating profits. Although we focus on developing new revenue and costmanagement initiatives to mitigate the negative effects resulting fromunfavorable changes in our supplier relationships, there can be no assurancethat our efforts will continue to completely offset the loss of these or otherdistribution rights. Please see “Risk Factors*—* We depend upon manufacturers who may be unable to provide productsof adequate quality or who may be unwilling to continue to supply products tous” in Item 1A of our Annual Report on Form 10-Kfor the fiscal year ended September 30, 2009.

 

We expect to continue to expand our productline offerings and to gain additional distribution rights over time througheither further negotiation with suppliers or by strategic acquisitions ofexisting distributors.  Although we arefocused on developing new revenue and cost management initiatives, there can beno assurance 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 ofour Annual Report on Form 10-K for the fiscal year ended September 30,2009.

 

36

----

Tableof Contents

 

·                  *High level of competition. *Sally Beauty Supply competes with other domestic and internationalbeauty product wholesale and retail outlets, including local and regionalopen-line beauty supply stores, professional-only beauty supply stores, salons,mass merchandisers, drug stores and supermarkets, as well as sellers on theinternet and salons retailing hair care items. BSG competes with other domesticand 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. Please see “Risk Factors — The beautyproducts distribution industry is highly competitive and is consolidating” in Item 1A of our Annual Report on Form 10-Kfor the fiscal year ended September 30, 2009.

 

·                  *Economic conditions.*  Weappeal to a wide demographic consumer profile and offer a broad selection ofbeauty products sold directly to retail consumers and salons and salonprofessionals. Historically, these factors have provided us with reducedexposure to downturns in economic conditions in the countries in which weoperate.  However, a downturn in theeconomy, especially for an extended period of time, could adversely impactconsumer demand of discretionary items such as beauty products and salon services,particularly affecting our electrical products category and our full-servicesales business. In addition, higher freight costs resulting from increases inthe cost of fuel, especially for an extended period of time, may impact ourexpenses at levels that we cannot pass through to our customers.  These factors could have a material adverseeffect on our business, financial condition and results of operations. Pleasesee “Risk Factors — A further downturn in the economy may affect consumer purchases of discretionaryitems such as beauty products and salon services, which could have a materialadverse effect on our business, financial condition and results of operations”in Item 1A of our Annual Report on Form 10-K for the fiscal year ended September30, 2009.

 

·                  *Controlling expenses*. Another important aspect of our business is our ability to controlcosts, especially in our BSG business segment, by right-sizing the business andmaximizing the efficiency of our structure. In late fiscal year 2009, we completedimplementation of an approximately $22.0 million capital spending program toconsolidate warehouses and reduce administrative expenses related to BSG’sdistribution network optimization program. We believe that annualized costsavings**from this program could approximate $10.0 million beginning infiscal year 2010. Please see “Risk Factors — We are not certain that ourongoing cost control plans will continue to be successful” in Item 1A of ourAnnual Report on Form 10-K for the fiscal year ended September 30, 2009.

 

·                  *Opening new stores*.  Ourfuture growth strategy depends in part on our ability to open and profitablyoperate new stores in existing and additional geographic areas. The capitalrequirements to open a U.S. - based Sally Beauty Supply or BSG store, excludinginventory, average approximately $70,000 and $80,000, respectively, with thecapital requirements for international stores costing less or substantiallymore depending upon the marketplace. However, in response to economicconditions and to allow flexibility to capitalize on potential real estaterevaluations in key locations, in the fiscal year 2009 we slowed our new storeopenings. We may not be able to open all of the new stores we plan to open andany new stores we open may not be profitable, any of which could have amaterial adverse impact on our financial condition or results of operations.Please see “Risk Factors — If we are unable to profitably open and operate newstores, our business, financial condition and results of operations may beadversely affected” in Item 1A of our Annual Report on Form 10-K for the fiscalyear ended September 30, 2009.

 

·                  *Changes to our informationtechnology systems*.  As ouroperations grow in both size and scope, we will continuously need to improveand upgrade our information systems and infrastructure while maintaining thereliability and integrity of our systems and infrastructure.  The expansion of our systems andinfrastructure will require us to commit substantial financial, operational andtechnical resources in advance of any increase in the volume of our business,with no assurance that the volume of business will increase.  Forexample, in fiscal year 2009, we began upgrading our distribution informationsystems (in connection with our capital spending program to consolidatewarehouses, as discussed above), upgrading our AS400 iSeries servers andinstalling Hyperion software to enhance our financial reporting system. Theseand any other required upgrades to our information systems and informationtechnology (or new technology), now or in the future, will require that ourmanagement and resources be diverted from our core business to assist incompletion of these projects. There can be no assurance that the time andresources our management will need to devote to these upgrades, service outagesor delays due to the installation of any new or upgraded technology (andcustomer issues therewith), or the impact on the reliability of our data fromany new or upgraded technology will not have a material adverse effect on ourfinancial reporting, business, financial condition or results of operations.  Please see “Risk Factors — We may beadversely affected by any 

 

37

----

Tableof Contents

 

disruption in our informationtechnology systems” in Item 1A of our Annual Report on Form 10-K for thefiscal year ended September 30, 2009.

 

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

##### *** ***

In November 2006, SallyHoldings, Inc. was converted to a Delaware limited liability company, wasrenamed “Sally Holdings LLC” and became an indirect wholly-owned subsidiary ofSally Beauty in connection with our separation from Alberto-Culver.  In this Quarterly Report on Form 10-Q, werefer to these transactions as the Separation Transactions. Sally Beauty wasformed in June 2006 and became the accounting successor company to SallyHoldings upon the completion of the Separation Transactions.  See the Company’s Annual Report on Form 10-Kfor the fiscal year ended September 30, 2009 for more information about theSeparation Transactions.

 

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

##### *** ***

*DerivativeInstruments*

 

The Company is exposed toa wide variety of risks, including risks arising from changing economicconditions. The Company manages its exposure to certain economic risks(including liquidity, credit risk and changes in interest rates) primarily (a) byclosely managing its cash flows from operating and investing activities and theamounts and sources of its debt obligations; (b) by assessing periodically thecreditworthiness of its business partners; and (c) through the use of interestrate swaps.  The Company uses interestrate swaps as part of its overall economic risk management strategy to addstability to the interest payments due in connection with its term loanobligations. Interest payments related to the term loans are impacted bychanges in LIBOR. Interest rate swap agreements involve the periodic receipt bythe Company of amounts based on a variable rate in exchange for the Companymaking payments based on a fixed rate over the term of the agreements withoutexchange of the underlying notional amount.

 

In November 2006, theCompany entered into four interest rate swap agreements with an aggregatenotional amount of $500 million. Interest rate swap agreements with anaggregate notional amount of $150 million expired in November 2008 andagreements with a notional amount of $350 million expired in November 2009.These interest rate swap agreements did not qualify as hedges and, therefore,the changes in fair value of these agreements were recorded in net interestexpense in our consolidated statements of earnings.

 

Additionally, in May 2008,the Company entered into two interest rate swap agreements with an aggregatenotional amount of $300 million. These interest rate swap agreements expire in May2012 and are designated as effective hedges, consistent with ASC 815.  Accordingly, adjustments to reflect thechange in the fair values of these interest rate swap agreements are recordedin accumulated other comprehensive income until the hedged obligation issettled or the swap agreements expire, whichever is earlier.  Any ineffectiveness is recognized in netinterest expense in the consolidated statements of earnings. Please see “Item3—Quantitative and Qualitative Disclosures about Market Risk—Interest rate risk”and Note 12 of the “Notes to Consolidated Financial Statements” in Item 8 - “FinancialStatements and Supplementary Data” contained in our Annual Report on Form 10-Kfor the fiscal year ended September 30, 2009.

 

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

 

As a result of the Company’s acquisition of Sinelco,on December 16, 2009, the Company, through Sinelco, uses foreign currencyoptions to manage the exposure to certain foreign currencies in connection withSinelco’s purchases of merchandise. The Company’s foreign currency optionagreements are not designated as hedges and do not meet the hedge accountingrequirements of ASC 815. Accordingly, thechanges in fair value of these derivative instruments (which are adjustedquarterly) are recorded in selling, general and administrative expenses in ourconsolidated statements of earnings. Selling, general and administrativeexpenses isnet of non-cash income of $0.3 millionofmarked-to-market adjustments related to these foreign currency options for thethree and six months ended March 31, 2010. During the six months ended March 31,2010, these derivative instruments did not have a material impact in results ofoperations or cash flows.

 

Our counterparties in theCompany’s interest rate swaps and foreign currency options are deemed to be ofsubstantial resources and strong creditworthiness. However, these transactionsresult in exposure to credit risks in the event of default by a counterparty.The recent financial crisis affecting the banking systems and financial marketshas resulted in many well-known financial institutions becoming lesscreditworthy or having diminished 

 

38

----

Tableof Contents

 

liquidity, which couldexpose us to an increased level of counterparty risk.  In the event that a counterparty defaults inits obligation under our derivative instruments, we could incur substantialfinancial loss. At March 31, 2010, the aggregate fair value of all our interestrate swaps was a net liability of $15.1 million andthe aggregate fair value of all our foreign currency options was a net asset of$0.4 million.

 

## **Results of Operations**

##  

The following table showsthe condensed results of operations of our business for the three and sixmonths ended March 31, 2010 and 2009 (in thousands):

 
| ** **                                      | ** ** | **Three  Months Ended********March 31,** | ** ** | **Six Months  Ended********March 31,** | ** ** |
|-------------------------------------------------|------------|------------------------------------------|------------|----------------------------------------|------------|
| ** **                                      | ** ** | **2010**                                 | ** ** | **2009**                               | ** ** | **2010** | ** ** | **2009** | ** ** |
| Net sales                                       |       | $                                        | 720,467    |                                   | $          | 641,511 |   | $ | 1,425,318 |   | $ | 1,287,087 |   |
| Cost of products sold and distribution expenses |       | 376,183                                  |       | 339,399                                |       | 747,819 |   | 681,431 |   |
| Gross profit                                    |       | 344,284                                  |       | 302,112                                |       | 677,499 |   | 605,656 |   |
| Total other operating costs and expenses        |       | 257,915                                  |       | 227,945                                |       | 518,545 |   | 463,229 |   |
| Operating earnings                              |       | 86,369                                   |       | 74,167                                 |       | 158,954 |   | 142,427 |   |
| Interest expense, net                           |       | 28,414                                   |       | 31,958                                 |       | 56,865 |   | 71,631 |   |
| Earnings before provision for income taxes      |       | 57,955                                   |       | 42,209                                 |       | 102,089 |   | 70,796 |   |
| Provision for income taxes                      |       | 22,089                                   |       | 16,470                                 |       | 38,861 |   | 27,850 |   |
| Net earnings                                    |       | $                                        | 35,866     |                                   | $          | 25,739 |   | $ | 63,228 |   | $ | 42,946 |   |

 

The following table showsthe condensed results of operations of our business for the three and sixmonths ended March 31, 2010 and 2009, expressed as a percentage of net salesfor each respective period shown:

 
| ** **                                      | ** ** | **Three  Months Ended********March 31,** | ** ** | **Six Months  Ended********March 31,** | ** ** |
|-------------------------------------------------|------------|------------------------------------------|------------|----------------------------------------|------------|
| ** **                                      | ** ** | **2010**                                 | ** ** | **2009**                               | ** ** | **2010** | ** ** | **2009** | ** ** |
| Net sales                                       |       | 100.0                                    | %          | 100.0                                  | %          | 100.0 | % | 100.0 | % |
| Cost of products sold and distribution expenses |       | 52.2                                     | %          | 52.9                                   | %          | 52.5 | % | 52.9 | % |
| Gross profit                                    |       | 47.8                                     | %          | 47.1                                   | %          | 47.5 | % | 47.1 | % |
| Total other operating costs and expenses        |       | 35.8                                     | %          | 35.5                                   | %          | 36.3 | % | 36.0 | % |
| Operating earnings                              |       | 12.0                                     | %          | 11.6                                   | %          | 11.2 | % | 11.1 | % |
| Interest expense, net                           |       | 3.9                                      | %          | 5.0                                    | %          | 4.0 | % | 5.6 | % |
| Earnings before provision for income taxes      |       | 8.1                                      | %          | 6.6                                    | %          | 7.2 | % | 5.5 | % |
| Provision for income taxes                      |       | 3.1                                      | %          | 2.6                                    | %          | 2.8 | % | 2.2 | % |
| Net earnings                                    |       | 5.0                                      | %          | 4.0                                    | %          | 4.4 | % | 3.3 | % |

 

39

----

Table of Contents

 

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

##### *** ***

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

 
| ** **                                                 | ** ** | **Three Months Ended********March 31,** | ** ** | **Six Months Ended********March 31,** | ** ** |
|------------------------------------------------------------|------------|-----------------------------------------|------------|---------------------------------------|------------|
| ** **                                                 | ** ** | **2010**                                | ** ** | **2009**                              | ** ** | **2010** | ** ** | **2009** | ** ** |
| Net sales:                                                 |       |                                    |       |                                  |       |   |   |   |   |
| Sally Beauty Supply                                        |       | $                                       | 453,634    |                                  | $          | 412,338 |   | $ | 891,949 |   | $ | 822,875 |   |
| BSG                                                        |       | 266,833                                 |       | 229,173                               |       | 533,369 |   | 464,212 |   |
| Total                                                      |       | $                                       | 720,467    |                                  | $          | 641,511 |   | $ | 1,425,318 |   | $ | 1,287,087 |   |
| Gross profit                                               |       | $                                       | 344,284    |                                  | $          | 302,112 |   | $ | 677,499 |   | $ | 605,656 |   |
| Gross profit margin                                        |       | 47.8                                    | %          | 47.1                                  | %          | 47.5 | % | 47.1 | % |
| Selling, general and administrative expenses               |       | $                                       | 245,485    |                                  | $          | 216,474 |   | $ | 494,226 |   | $ | 440,011 |   |
| Depreciation and amortization                              |       | $                                       | 12,430     |                                  | $          | 11,471 |   | $ | 24,319 |   | $ | 23,218 |   |
| Earnings before provision for income taxes:                |       |                                    |       |                                  |       |   |   |   |   |
| Segment operating profit:                                  |       |                                    |       |                                  |       |   |   |   |   |
| Sally Beauty Supply                                        |       | $                                       | 79,520     |                                  | $          | 70,379 |   | $ | 150,626 |   | $ | 135,665 |   |
| BSG                                                        |       | 26,027                                  |       | 20,359                                |       | 51,624 |   | 40,595 |   |
| Segment operating profit                                   |       | 105,547                                 |       | 90,738                                |       | 202,250 |   | 176,260 |   |
| Unallocated expenses                                       |       | (16,947                                 | )          | (15,147                               | )          | (36,242 | ) | (28,941 | ) |
| Share-based compensation expense                           |       | (2,231                                  | )          | (1,424                                | )          | (7,054 | ) | (4,892 | ) |
| Operating earnings                                         |       | 86,369                                  |       | 74,167                                |       | 158,954 |   | 142,427 |   |
| Interest expense, net of interest income                   |       | (28,414                                 | )          | (31,958                               | )          | (56,865 | ) | (71,631 | ) |
| Earnings before provision for income taxes                 |       | $                                       | 57,955     |                                  | $          | 42,209 |   | $ | 102,089 |   | $ | 70,796 |   |
| Segment operating profit margin:                           |       |                                    |       |                                  |       |   |   |   |   |
| Sally Beauty Supply                                        |       | 17.5                                    | %          | 17.1                                  | %          | 16.9 | % | 16.5 | % |
| BSG                                                        |       | 9.8                                     | %          | 8.9                                   | %          | 9.7 | % | 8.7 | % |
| Consolidated operating profit margin                       |       | 12.0                                    | %          | 11.6                                  | %          | 11.2 | % | 11.1 | % |
| Number of stores at end-of-period (including  franchises): |       |                                    |       |                                  |       |   |   |   |   |
| Sally Beauty Supply                                        |       |                                    |       |                                  |       | 2,946 |   | 2,873 |   |
| BSG                                                        |       |                                    |       |                                  |       | 1,007 |   | 934 |   |
|                                                       |       |                                    |       |                                  |       | 3,953 |   | 3,807 |   |
| Same store sales growth (a)                                |       |                                    |       |                                  |       |   |   |   |   |
| Sally Beauty Supply                                        |       | 4.3                                     | %          | 2.0                                   | %          | 4.0 | % | 0.9 | % |
| BSG                                                        |       | 6.1                                     | %          | 2.3                                   | %          | 5.2 | % | 1.5 | % |
| Consolidated                                               |       | 4.8                                     | %          | 2.1                                   | %          | 4.3 | % | 1.1 | % |

 

----

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

 

40

----

Tableof Contents

 

***TheThree Months Ended March 31, 2010 compared to the Three Months Ended March 31,2009***

 

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

 
|                             |   | **Three Months Ended March 31,** |       |
|----------------------------------|--------|----------------------------------|------------|
|                             |   | **2010**                         | ** ** | **2009** | ** ** | **Increase** |   |
| Net sales:                       |   |                             |       |   |   |   |   |   |   |
| Sally Beauty Supply              |   | $                                | 453,634    |   | $ | 412,338 |   | $ | 41,296 |   | 10.0 | % |
| BSG                              |   | 266,833                          |       | 229,173 |   | 37,660 |   | 16.4 | % |
| Consolidated net sales           |   | $                                | 720,467    |   | $ | 641,511 |   | $ | 78,956 |   | 12.3 | % |
|                             |   |                             |       |   |   |   |   |   |   |
| Gross profit:                    |   |                             |       |   |   |   |   |   |   |
| Sally Beauty Supply              |   | $                                | 240,940    |   | $ | 214,765 |   | $ | 26,175 |   | 12.2 | % |
| BSG                              |   | 103,344                          |       | 87,347 |   | 15,997 |   | 18.3 | % |
| Consolidated gross profit        |   | $                                | 344,284    |   | $ | 302,112 |   | $ | 42,172 |   | 14.0 | % |
|                             |   |                             |       |   |   |   |   |   |   |
| Gross profit margin:             |   |                             |       |   |   |   |   |   |   |
| Sally Beauty Supply              |   | 53.1                             | %          | 52.1 | % | 1.0 | % |   |   |
| BSG                              |   | 38.7                             | %          | 38.1 | % | 0.6 | % |   |   |
| Consolidated gross profit margin |   | 47.8                             | %          | 47.1 | % | 0.7 | % |   |   |

###  

### ***Net Sales***

###  

Consolidated net sales increased by $79.0 million, or 12.3%, for thethree months ended March 31, 2010 compared to the three months ended March 31,2009. Company-operated stores that have been open for at least 14 monthscontributed an increase of approximately $50.9 million, or 7.9%, and sales frombusinesses acquired in the preceding 12 months contributed approximately $22.7million, or 3.5%, more to consolidated net sales for the three months ended March31, 2010 compared to the three months ended March 31, 2009. Other saleschannels, in the aggregate, contributed an increase of $5.4 million, or 0.8%,compared to the three months ended March 31, 2009. Consolidated net sales forthe three months ended March 31, 2010 are inclusive of approximately $11.6million in positive impact from changes in foreign exchange rates.

 

*Sally Beauty Supply*.  Net sales for Sally Beauty Supply increasedby $41.3 million, or 10.0%, for the three months ended March 31, 2010 comparedto the three months ended March 31, 2009. In the Sally Beauty Supply segment, company-operated stores that havebeen open for at least 14 months contributed an increase of approximately $37.9million, or 9.2%, and sales from businesses acquired in the preceding 12 monthscontributed approximately $2.8 million, or 0.7%, more for the three monthsended March 31, 2010 compared to the three months ended March 31, 2009. Othersales channels and stores that have been open for less than 14 months, in theaggregate, contributed an increase of $0.6 million, or 0.1%, compared to thethree months ended March 31, 2009. Net sales for Sally Beauty Supply for thethree months ended March 31, 2010 are inclusive of approximately $6.8 millionin positive impact from changes in foreign exchange rates.

 

*BeautySystems Group*.  Net sales for BSG increased by $37.7 million,or 16.4%, for the three months ended March 31, 2010 compared to the threemonths ended March 31, 2009. In the BSG segment, company-operated stores thathave been open for at least 14 months contributed an increase of approximately$13.0 million, or 5.7% and sales from stores that have been open for less than14 months contributed an increase of approximately $2.2 million, or 1.0%, whilesales from businesses acquired in the preceding 12 months contributedapproximately $19.9 million, or 8.7%, more for the three months ended March 31,2010compared tothe three months ended March 31, 2009. Other sales channels, in the aggregate,contributed an increase of $2.6 million, or 1.1%, compared to the three monthsended March 31, 2009. Net sales for BSG for the three months ended March 31,2010 are inclusive of approximately $4.8 million in positive impact fromchanges in foreign exchange rates.

 

41

----

#### **Table of Contents**

 

#### ***Gross Profit***

#### ** **

Consolidated gross profit increased by $42.2 million, or 14.0%, for thethree months ended March 31, 2010 compared to the three months ended March 31,2009, principally due to higher sales volume and improved gross margins in bothbusiness segments as more fully described below.

 

*Sally Beauty Supply*. Sally BeautySupply’s gross profit increased by $26.2 million, or 12.2%, for the threemonths ended March 31, 2010 compared to the three months ended March 31, 2009,principally as a result of a higher sales volume and improved grossmargins.  Sally Beauty Supply’s grossprofit as a percentage of net sales increased to 53.1% for the three monthsended March 31, 2010 compared to 52.1% for the three months ended March 31,2009. This increase was principally the result of continued benefits fromlow-cost sourcing initiatives and a shift in product and customer mix(including an increase in sales of exclusive-label products and otherhigher-margin products). This increase also reflects a $3.1 million favorableimpact from changes in foreign exchange rates.

 

*Beauty Systems Group*.  BSG’s gross profit increased by $16.0million, or 18.3%, for the threemonths ended March 31, 2010 compared to the three months ended March 31, 2009, principallyas a result of higher sales volume and improved gross margins. BSG’s gross profit as apercentage of net sales was 38.7% for the three months ended March 31, 2010 compared to38.1% forthe threemonths ended March 31, 2009. This increase was principally the result of afavorable change in the sales mix principally in BSG’s franchise business. This increasealso reflects a $2.0million favorable impact from changes in foreign exchange rates.

 

#### ***Selling, General and AdministrativeExpenses***

#### ** **

Consolidated selling, general and administrative expenses increased by$29.0 million, or 13.4%, to $245.5 million for the three months ended March 31,2010 compared to $216.5 million for the three months ended March 31, 2009.Selling, general and administrative expenses, as a percentage of net sales,were 34.1% for the three months ended March 31, 2010 compared to 33.7% for thethree months ended March 31, 2009. This increase was attributable toincremental expenses (including employee compensation, rent and otheroccupancy-related expenses) resulting from stores opened and from businessesacquired in the preceding 12 months, as well as higher share-based compensationexpense of $0.8 million and higher advertising expenses in the Sally BeautySupply segment of $0.9 million.

 

***Depreciation and Amortization***

 

Consolidated depreciationand amortization was $12.4 million for the three months ended March 31, 2010compared to $11.5 million for the three months ended March 31, 2009. Thisincrease reflects the incremental expenses associated with businesses acquiredin the last 12 months and depreciation related to capital expenditures mainlyin connection with store openings in both operating segments, partially offsetby the impact of assets that became fully depreciated in the preceding 12months.

 

#### ***Operating Earnings***

#### ** **

The following table setsforth, for the periods indicated, information concerning our operating earningsfor each reportable segment (dollars in thousands):

 
|                              |   | **Three Months Ended March 31,** |       |
|-----------------------------------|--------|----------------------------------|------------|
|                              |   | **2010**                         | ** ** | **2009** | ** ** | **Increase** |   |
| Operating  Earnings:              |   |                             |       |   |   |   |   |   |   |
| Segment  operating profit:        |   |                             |       |   |   |   |   |   |   |
| Sally Beauty  Supply              |   | $                                | 79,520     |   | $ | 70,379 |   | $ | 9,141 |   | 13.0 | % |
| BSG                               |   | 26,027                           |       | 20,359 |   | 5,668 |   | 27.8 | % |
| Segment  operating profit         |   | 105,547                          |       | 90,738 |   | 14,809 |   | 16.3 | % |
| Unallocated  expenses             |   | (16,947                          | )          | (15,147 | ) | 1,800 |   | 11.9 | % |
| Share-based  compensation expense |   | (2,231                           | )          | (1,424 | ) | 807 |   | 56.7 | % |
| Operating  earnings               |   | $                                | 86,369     |   | $ | 74,167 |   | $ | 12,202 |   | 16.5 | % |

 

Consolidated operating earnings increased by $12.2 million, or 16.5%,to $86.4 million for three months ended March 31, 2010 compared to $74.2million for the three months ended March 31, 2009. The increase in consolidatedoperating earnings was due primarily to an increase in the operating profits ofboth segments, partially offset by higher unallocated corporate expenses andshare-based compensation expense, as discussed below. Operating earnings, as apercentage of net sales, were 12.0% for the three months ended March 31, 2010compared to 11.6% for the three months ended March 31, 2009.

 

*Sally Beauty Supply*.  Sally Beauty Supply’s segment operatingearnings increased by $9.1 million, or 13.0%, to $79.5 million for three monthsended March 31, 2010 compared to $70.4 million for the three months ended March

 

42

----

Table of Contents

 

31, 2009.  The increase in SallyBeauty Supply’s segment operating earnings was primarily a result of increasedsame store sales volume and improved gross margins, partially offset by higheradvertising costs of approximately $0.9 million and the incremental costsrelated to approximately 73 additional company-operated stores (stores openedor acquired during the past twelve months) operating during the three monthsended March 31, 2010.  Segment operatingearnings, as a percentage of net sales, were 17.5% for the three months ended March31, 2010 compared to 17.1% for the three months ended March 31, 2009. Theincrease in Sally Beauty Supply’s operating earnings as a percentage of segmentnet sales was primarily a result of gross margin improvements.

 

*Beauty Systems Group*.  BSG’s segment operating earnings increased by$5.7 million, or 27.8%, to $26.0 million for the three months ended March 31,2010 compared to $20.4 million for the three months ended March 31, 2009.Segment operating earnings, as a percentage of net sales, increased to 9.8% forthe three months ended March 31, 2010 compared to 8.9% for the three monthsended March 31, 2009. The increase in BSG operating earnings was primarily aresult of gross margin improvements, the incremental operating earnings ofbusinesses acquired and to ongoing cost reduction initiatives (including costsavings realized from the warehouse optimization program that began in thefiscal year 2007).

 

*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, increased by $1.8 million, or 11.9%, to $16.9 million for the threemonths ended March 31, 2010 compared to $15.1 million for the three monthsended March 31, 2009. This increase was due primarily to higher employeecompensation and compensation-related expenses of approximately $1.4 million,other corporate expenses of approximately $1.0 million related primarily torecent upgrades to our information technology systems and acquisitions,partially offset by favorable currency transactions of approximately $0.6million resulting from intercompany notes not permanently invested.

 

#### ***Share-based Compensation Expense.***Total compensation costcharged against income for share-based compensation arrangements increased $0.8million to $2.2 million for the three months ended March31, 2010 compared to $1.4million for the three months ended March 31,2009. This increase was due tothe higher fair value at the grant date of stock option awards during thefiscal year 2010 compared to stock option awards during the fiscal year 2009.

#### ** **

#### ***Net Interest Expense***

#### ** **

Net interest expensedecreased $3.6 million to $28.4 million for the three months ended March 31,2010 compared to $32.0 million for the three months ended March 31, 2009.  Net interest expense for the three monthsended March 31, 2009 is net of interest income of $0.1 million. The decrease innet interest expense was primarily attributable to lower outstanding principalbalances on our ABL facility and senior term loans and lower prevailing LIBORinterest rates, partially offset by non-cash income of $2.2 million ofmarked-to-market adjustments for certain interest rate swaps (please see Note 7of the Condensed Notes to Consolidated Financial Statements) in the threemonths ended March 31, 2009 with no comparable amount in 2010.

 

#### ***Provision for Income Taxes***

#### ** **

Provision for incometaxes was $22.1 million during the three months ended March 31, 2010 comparedto $16.5 million for the three months ended March 31, 2009.  Income taxes for the interim periods ended March31, 2010 and 2009 have been included in the accompanying financial statementson the basis of an estimated annual effective rate.  The estimated annual effective tax rate(excluding discrete items) is 37.6% for the fiscal year 2010 compared to theactual tax rate of 39.0% for the full fiscal year 2009.  The decrease in the estimated annualeffective tax rate primarily relates to a decrease in the losses subject tovaluation allowances.

 

The actual tax rate forthe three months ended March 31, 2010 exceeds the estimated annual effectivetax rate (excluding discrete items) for fiscal year 2010 primarily because oflosses recorded in the three months ended March 31, 2010 for entities for whicha valuation allowance is required, and discrete tax items recorded in the threemonths ended March 31, 2010.

 

#### ***Net Earnings***

#### ** **

As a result of theforegoing, consolidated net earnings increased by $10.1 million, or 39.3%, to$35.9 million for the three months ended March 31, 2010 compared to $25.7million for the three months ended March 31, 2009. Net earnings, as apercentage of net sales, were 5.0% for the three months ended March 31, 2010compared to 4.0% for the three months ended March 31, 2009.

 

43

----

Tableof Contents

 

***The SixMonths Ended March 31, 2010 compared to the Six Months Ended March 31, 2009***

 

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

 
| ** **                       | ** ** | **Six Months Ended March 31,** | ** ** |
|----------------------------------|------------|--------------------------------|------------|
| ** **                       | ** ** | **2010**                       | ** ** | **2009** | ** ** | **Increase** | ** ** |
| Net sales:                       |       |                           |       |   |   |   |   |   |   |
| Sally Beauty Supply              |       | $                              | 891,949    |   | $ | 822,875 |   | $ | 69,074 |   | 8.4 | % |
| BSG                              |       | 533,369                        |       | 464,212 |   | 69,157 |   | 14.9 | % |
| Consolidated net sales           |       | $                              | 1,425,318  |   | $ | 1,287,087 |   | $ | 138,231 |   | 10.7 | % |
|                             |       |                           |       |   |   |   |   |   |   |
| Gross profit:                    |       |                           |       |   |   |   |   |   |   |
| Sally Beauty Supply              |       | $                              | 471,204    |   | $ | 427,693 |   | $ | 43,511 |   | 10.2 | % |
| BSG                              |       | 206,295                        |       | 177,963 |   | 28,332 |   | 15.9 | % |
| Consolidated gross profit        |       | $                              | 677,499    |   | $ | 605,656 |   | $ | 71,843 |   | 11.9 | % |
|                             |       |                           |       |   |   |   |   |   |   |
| Gross profit margin:             |       |                           |       |   |   |   |   |   |   |
| Sally Beauty Supply              |       | 52.8                           | %          | 52.0 | % | 0.8 | % |   |   |
| BSG                              |       | 38.7                           | %          | 38.3 | % | 0.4 | % |   |   |
| Consolidated gross profit margin |       | 47.5                           | %          | 47.1 | % | 0.4 | % |   |   |

###  

### ***Net Sales***

###  

Consolidated net sales increased by $138.2 million, or 10.7%, for thesix months ended March 31, 2010 compared to the six months ended March 31,2009. Company-operated stores that have been open for at least 14 monthscontributed an increase of approximately $99.0 million, or 7.7%, and sales frombusinesses acquired in the preceding 12 months contributed approximately $37.0million, or 2.9%, more to consolidated sales for the six months ended March 31,2010 compared to the six months ended March 31, 2009. Sales through our BSGfranchise-based businesses declined by approximately $1.8 million, or 0.1%.Other sales channels, in the aggregate, contributed an increase of $4.0million, or 0.3%, compared to the six months ended March 31, 2009. Consolidatednet sales for the six months ended March 31, 2010 are inclusive ofapproximately $20.7 million in positive impact from changes in foreign exchangerates.

 

*Sally Beauty Supply*.  Net sales for Sally Beauty Supply increasedby $69.1 million, or 8.4%, for the six months ended March 31, 2010 compared tothe six months ended March 31, 2009.  Inthe Sally Beauty Supply segment, company-operated stores that have been openfor at least 14 months contributed an increase of approximately $74.2 million,or 9.0%, while sales from businesses acquired in the preceding 12 monthscontributed approximately $5.4 million, or 0.7%, less to net sales for the sixmonths ended March 31, 2010 compared to the six months ended March 31, 2009.Net sales for Sally Beauty Supply for the six months ended March 31, 2010 areinclusive of approximately $12.0 million in positive impact from changes inforeign exchange rates.

 

*BeautySystems Group*.  Net sales for BSG increased by $69.2 million,or 14.9%, for the six months ended March 31, 2010 compared to the six monthsended March 31, 2009. Company-operated stores that have been open for at least14 months contributed an increase of approximately $24.9 million, or 5.4%,sales from stores that have been open for less than 14 months contributed anincrease of approximately $2.3 million, or 0.5%, and sales through distributorsales consultants increased approximately $1.4 million, or 0.3%. Sales frombusinesses acquired in the preceding 12 months contributed approximately $ 42.4million, or 9.1%, more to net sales for the six months ended March 31, 2010compared to the six months ended March 31, 2009. Sales through ourfranchise-based businesses declined by approximately $1.8 million, or 0.4%,primarily due to lower trade show activity. Net sales for BSG for the sixmonths ended March 31, 2010 are inclusive of approximately $8.7 million inpositive impact from changes in foreign exchange rates.

 

44

----

#### **Table of Contents**

 

#### ***Gross Profit***

#### ** **

Consolidated gross profit increased by $71.8 million, or 11.9%, for thesix months ended March 31, 2010 compared to the six months ended March 31, 2009,principally due to higher sales volume and improved gross margins in bothbusiness segments as more fully described below.

 

*Sally Beauty Supply*. Sally BeautySupply’s gross profit increased by $43.5 million, or 10.2%, for the six monthsended March 31, 2010 compared to the six months ended March 31, 2009,principally as a result of a higher sales volume and improved grossmargins.  Sally Beauty Supply’s grossprofit as a percentage of net sales increased to 52.8% for the six months endedMarch 31, 2010 compared to 52.0% for the six months ended March 31, 2009. Thisincrease was the result of continued benefits from low-cost sourcinginitiatives and a shift in product and customer mix (including an increase insales of exclusive-label products and other higher-margin products). Thisincrease also reflects a $5.6 million favorable impact from changes in foreignexchange rates.

 

*Beauty Systems Group*.  BSG’s gross profit increased by $28.3million, or 15.9%, for the sixmonths ended March 31, 2010 compared to the six months ended March 31, 2009, principallyas a result of higher sales volume and improved gross margins. BSG’s gross profit as apercentage of net sales increased to 38.7% for the six months ended March 31, 2010 compared to 38.3%forthe sixmonths ended March 31, 2009. This increase was principally the result of afavorable change in the sales mix in BSG’s franchise business and in itscompany-operated stores mainly in the U.S. This increase also reflects a $3.7 million favorable impact fromchanges in foreign exchange rates.

 

#### ***Selling, General and AdministrativeExpenses***

#### ** **

Consolidated selling, general and administrative expenses increased by$54.2 million, or 12.3%, to $494.2 million for the six months ended March 31,2010 compared to $440.0 million for the six months ended March 31, 2009.Selling, general and administrative expenses, as a percentage of net sales,were 34.7% for the six months ended March 31, 2010 compared to 34.2% for thesix months ended March 31, 2009. This increase was attributable to incrementalexpenses (including employee compensation, rent and other occupancy-relatedexpenses) resulting from stores opened and from businesses acquired in thepreceding 12 months, as well as higher share-based compensation expense of $2.2million, higher advertising expenses in the Sally Beauty Supply segment of $3.7million and acquisition—related expenses of $0.5 million. Please see “RecentAccounting Pronouncements” below for more information about the Company’streatment of acquisition—related expenses.

 

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

#### ** **

Consolidated depreciationand amortization was $24.3 million for the six months ended March 31, 2010compared to $23.2 million for the six months ended March 31, 2009. Thisincrease reflects the incremental expenses associated with businesses acquiredin the last 12 months and depreciation related to capital expenditures mainlyin connection with store openings in both operating segments, partially offsetby the impact of assets that became fully depreciated in the preceding 12months.

 

#### ***Operating Earnings***

#### ** **

The following table setsforth, for the periods indicated, information concerning our operating earningsfor each reportable segment (dollars in thousands):

 
| ** **                        | ** ** | **Six Months Ended March 31,** | ** **                                         |
|-----------------------------------|------------|--------------------------------|----------------------------------------------------|
| ** **                        | ** ** | **2010**                       | ** **                                         | **2009** | ** ** | **Increase** | ** ** |
| Operating  Earnings:              |       |                           |                                               |   |   |   |   |   |   |
| Segment  operating profit:        |       |                           |                                               |   |   |   |   |   |   |
| Sally Beauty  Supply              |       | $                              | 150,626                                            |   | $ | 135,665 |   | $ | 14,961 |   | 11.0 | % |
| BSG                               |       | 51,624                         |                                               | 40,595 |   | 11,029 |   | 27.2 | % |
| Segment  operating profit         |       | 202,250                        |                                               | 176,260 |   | 25,990 |   | 14.7 | % |
| Unallocated  expenses             |       | (36,242                        | )                                                  | (28,941 | ) | 7,301 |   | 25.2 | % |
| Share-based  compensation expense |       | (7,054                         | )                                                  | (4,892 | ) | 2,162 |   | 44.2 | % |
| Operating  earnings               |       | $                              |         158,954 |   | $ |          142,427 |   | $ |          16,527 |   | 11.6 | % |

 

Consolidated operating earnings increased by $16.5 million, or 11.6%,to $159.0 million for six months ended March 31, 2010 compared to $142.4million for the six months ended March 31, 2009. The increase in consolidatedoperating earnings was due primarily to an increase in the operating profits ofboth segments, partially offset by higher unallocated corporate expenses andshare-based compensation expense, as discussed below. Operating earnings, as apercentage of net sales, were 11.2% for the six months ended March 31, 2010compared to 11.1% for 

 

45

----

Table of Contents

 

the six months ended March 31, 2009.

 

*Sally Beauty Supply*.  Sally Beauty Supply’s segment operatingearnings increased by $15.0 million, or 11.0%, to $150.6 million for the sixmonths ended March 31, 2010 compared to $135.7 million for the six months endedMarch 31, 2009.  The increase in SallyBeauty Supply’s segment operating earnings was primarily a result of increasedsame store sales volume and improved gross margins, partially offset by higheradvertising costs of approximately $3.7 million and the incremental costsrelated to approximately 73 additional company-operated stores (stores openedor acquired during the past twelve months) operating during the six monthsended March 31, 2010.  Segment operatingearnings, as a percentage of net sales, were 16.9% for the six months ended March31, 2010 compared to 16.5% for the six months ended March 31, 2009. Theincrease in Sally Beauty Supply’s operating earnings, as a percentage ofsegment net sales, was primarily a result of gross margin improvements.

 

*Beauty Systems Group*.  BSG’s segment operating earnings increased by$11.0 million, or 27.2%, to $51.6 million for the six months ended March 31,2010 compared to $40.6 million for the six months ended March 31, 2009. Segmentoperating earnings, as a percentage of net sales, increased to 9.7% for the sixmonths ended March 31, 2010 compared to 8.7% for the six months ended March 31,2009. The increase in BSG operating earnings was primarily a result of grossmargin improvements, the incremental operating earnings of businesses acquiredand to ongoing cost reduction initiatives (including cost savings realized fromthe warehouse optimization program that began in the fiscal year 2007).

 

*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, increased by $7.3 million, or 25.2%, to $36.2 million for the sixmonths ended March 31, 2010 compared to $28.9 million for the six months ended March31, 2009. This increase was due primarily to higher employee compensation andcompensation-related expenses of approximately $3.7 million, unfavorablecurrency transactions of approximately $0.9 million resulting from intercompanynotes not permanently invested, other corporate expenses of approximately $1.7million related primarily to recent upgrades to our information technologysystems, and acquisition—related expenses of approximately $0.5 million(representing legal, professional fees and other expenses).

 

#### ***Share-based Compensation Expense.***Total compensation costcharged against income for share-based compensation arrangements increased $2.2million to $7.1 million for the six months ended March31, 2010 compared to $4.9million for the six months ended March 31,2009. This increase was due tothe higher fair value at the grant date of stock option awards during the sixmonths ended March 31, 2010 compared to stock option awards during the sixmonths ended March 31, 2009.

#### ** **

#### ***Net Interest Expense***

#### ** **

Net interest expensedecreased $14.7 million to $56.9 million for the six months ended March 31,2010 compared to $71.6 million for the six months ended March 31, 2009.  Net interest expense is net of interestincome of $0.1 million and $0.2 million for the six months ended March 31, 2010and 2009, respectively. The decrease in net interest expense was primarilyattributable to a $3.1 million favorable change in the fair value of certaininterest rate swaps (please see Note 7 of the Condensed Notes to ConsolidatedFinancial Statements), to lower outstanding principal balances on our ABLfacility and senior term loans and to lower prevailing LIBOR interest rates.

 

#### ***Provision for Income Taxes***

#### ** **

Provision for incometaxes was $38.9 million during the six months ended March 31, 2010 compared to$27.9 million for the six months ended March 31, 2009.  Income taxes for the interim periods ended March31, 2010 and 2009 have been included in the accompanying financial statementson the basis of an estimated annual effective rate.  The estimated annual effective tax rate (excludingdiscrete items) is 37.6% for the fiscal year 2010 compared to the actual taxrate of 39.0% for the full fiscal year 2009. The decrease in the estimated annual effective tax rate primarilyrelates to a decrease in the losses subject to valuation allowances.

 

The actual tax rate forthe six months ended March 31, 2010 exceeds the estimated annual effective taxrate (excluding discrete items) for fiscal year 2010 primarily because of thediscrete tax items recorded in the six months ended March 31, 2010.

 

#### ***Net Earnings***

#### ** **

As a result of theforegoing, consolidated net earnings increased by $20.3 million, or 47.2%, to$63.2 million for the six months ended March 31, 2010 compared to $42.9 millionfor the six months ended March 31, 2009. Net 

 

46

----

Table ofContents

 

earnings, as a percentageof net sales, were 4.4% for the six months ended March 31, 2010 compared to3.3% for the six months ended March 31, 2009.

 

## **Financial Condition**

##  

##### ***March 31, 2010 Compared to September 30, 2009***

##### *** ***

Working capital (currentassets less current liabilities) increased $19.6 million to $335.5 million at March31, 2010 compared to $315.9 million at September 30, 2009. The ratio of currentassets to current liabilities was 1.84 to 1.00 at March 31, 2010 compared to1.79 to 1.00 at September 30, 2009. The increase in working capital reflects anincrease of $16.9 million in current assets and a decrease of $2.6 million incurrent liabilities.  The increase incurrent assets as of March 31, 2010 includes an increase of $19.3 million ininventory levels, an increase of $8.5 million in other receivables and anincrease of $4.4 million in trade accounts receivable, partially offset by areduction of $17.0 million in cash and cash equivalents.  The decrease in current liabilities as of March31, 2010 includes a reduction of $20.9 million in current maturities oflong-term debt, partially offset by an increase of $14.0 million in accountspayable and accrued expenses and a net increase of $6.1 million in the amountdue to Sally Beauty.

 

Inventories increased $19.3 million to $579.0 million at March 31, 2010compared to $559.7 million at September 30, 2009 due primarily to the effect ofstores opened and businesses acquired in the preceding 12 months partiallyoffset by the effect of foreign currency translation adjustments ofapproximately $3.4 million. Other receivables increased $8.5 million to $32.6million at March 31, 2010 compared to $24.1 million at September 30, 2009 dueprimarily to accrued vendor rebates and businesses acquired. Trade accountsreceivable increased $4.4 million to $48.0 million at March 31, 2010 comparedto $43.6 million at September 30, 2009 due primarily to increased salesactivity and businesses acquired.

 

Accounts payable increased $9.2 million to $202.8 million at March 31,2010 compared to $193.6 million at September 30, 2009 due primarily toacquisitions and the timing of payments to suppliers in connection with recentpurchases of merchandise inventory. Accrued expenses increased $4.8 million to$158.6 million at March 31, 2010 compared to $153.8 million at September 30,2009 due primarily to the timing of payments of interest on long-term debt. Theamount due to Sally Beauty increased $6.1 million to $28.1 million at March 31,2010 compared to $22.0 million at September 30, 2009 due primarily to anincrease in the federal income tax liability of the Company and itsconsolidated subsidiaries, partially offset by corporate expenses (such ascorporate income tax, board of director expenses and public company expenses)and other corporate expenditures paid on behalf of our indirect parent SallyBeauty.

 

Long-term debt, including current portion, decreased $38.4 million to$1,639.1 million at March 31, 2010 compared to $1,677.5 million at September 30,2009 due primarily to prepayments of $50.3 million (including a mandatoryprepayment of $22.3 million — please see “Liquidity and Capital Resources”below) on our senior term loans, partially offset by pre-acquisitionindebtedness, including capital leases, of Sinelco.

 

Total member’s deficit,for the six months ended March 31, 2010, decreased by $55.7 million primarilyas a result of net earnings of $63.2 million, partially offset by cumulativetranslation adjustments of $7.7 million.

 

## **Liquidity and Capital Resources**

##  

We broadly defineliquidity as our ability to generate sufficient cash flow from operatingactivities to meet our obligations and commitments. In addition, liquidityincludes the ability to obtain appropriate debt and equity financing and toconvert into cash those assets that are no longer required to meet existingstrategic and financial objectives. Therefore, liquidity cannot be considered separatelyfrom capital resources that consist of current or potentially available fundsfor use in achieving long-range business objectives and meeting debt servicecommitments. Please see our Annual Report on Form 10-K for the fiscal yearended September 30, 2009 for additional information on liquidity and capitalresources.

 

Following the completionof the Separation Transactions, we are highly leveraged and a substantialportion of our liquidity needs will arise from debt service on indebtednessincurred primarily in connection with the Separation Transactions and fromfunding the costs of operations, working capital and capital expenditures. As aholding company, we depend on our subsidiaries to distribute funds to us sothat we may pay our obligations and expenses. Please see “Risk Factors—RisksRelating to Our Business,” and “—Risks Relating to Our Substantial Indebtedness”in Item 1A of our Annual Report on Form 10-K for the fiscal year ended September30, 2009.

 

The senior term loanfacilities may be prepaid at the option of the Company at any time withoutpremium or penalty and are subject to mandatory prepayment in an amount equalto 50% of excess cash flow (as defined in the agreement governing the term loanfacilities) for any fiscal year unless a specified leverage ratio is met. In January2010, the Company made a mandatory prepayment on the senior term loanfacilities in the amount of $22.3 million. 

 

47

----

Tableof Contents

 

Amounts paid pursuant tosaid provision may be applied, at the option of the Company, against minimumloan repayments otherwise required of us over the twelve-month period followingany such payment under the terms of the loan agreement.

 

During the six monthsended March 31, 2010, the Company also made optional prepayments in theaggregate amount of $28.0 million on its senior term loans. In connection withthe mandatory and optional prepayments made during the six months ended March 31,2010, the Company recorded losses on extinguishment of debt in the aggregateamount of $0.4 million, which are included in net interest expense in theCompany’s consolidated statements of earnings.

 

Based upon the currentlevel of operations and anticipated growth, we anticipate that existing cashbalances, funds expected to be generated by operations and funds availableunder the ABL facility will be sufficient to meet our working capitalrequirements and to finance anticipated capital expenditures and potentialacquisitions over the next 12 months.

 

There can be no assurancethat our business will generate sufficient cash flows from operations, thatanticipated net sales growth and operating improvements will be realized orthat future borrowings will be available under our ABL facility in an amountsufficient to enable us to service our indebtedness or to fund our otherliquidity needs. In addition, our ability to meet our debt service obligationsand liquidity needs are subject to certain risks, which include, but are notlimited to, increases in competitive activity, the loss of key suppliers,rising interest rates, the loss of key personnel, the ability to execute ourbusiness strategy and general economic conditions. Please see “Risk Factors” inItem 1A of our AnnualReport on Form 10-K for the year ended September 30, 2009.

 

We utilize our ABL facilityfor the issuance of letters of credit, as well as to manage normal fluctuationsin operational cash flow. In that regard, we may from time to time draw fundsunder the revolving credit facility for general corporate purposes includingacquisitions and interest payments due on our indebtedness.  The funds drawn on individual occasions duringthe six months ended March 31, 2010 have varied in amounts of up to $30.0**million, with total amounts outstandingranging from zero up to $53.5 million. The amounts drawn are generally paiddown with cash provided by our operating activities.

 

As of March 31, 2010, we had$336.4 million available for additional borrowings under our ABL facility,subject to borrowing base limitations, as reduced by outstanding letters ofcredit.

 

We may from time to time repurchase or otherwiseretire our debt and take other steps to reduce our debt or otherwise improveour balance sheet. These actions may include open market repurchases of ournotes, prepayments of our term loans or other retirements of outstanding debt.The amount of debt that may be repurchased or otherwise retired, if any, wouldbe decided upon at the sole discretion of Sally Beauty’s Board of Directors andwill depend on market conditions, trading levels of the Company’s debt fromtime to time, the Company’s cash position and other considerations.

 

We are a holding companyand do not have any material assets or operations other than ownership ofequity interests of our subsidiaries. The agreements and instruments governing the debt of us and oursubsidiaries contain material limitations on our ability to pay dividends andother restricted payments to our indirect parent, Sally Beauty.

 

Under the agreements andindentures governing the term loan facilities and the notes, we may not makecertain restricted payments to Sally Beauty if a default then exists under thecredit agreement or the indentures or if our consolidated interest coverageratio is less than 2.0 to 1.0 at the time of the making of such restrictedpayment.  As of March 31, 2010, ourconsolidated interest coverage ratio exceeded 2.0 to 1.0.  Further, the aggregate amount of restrictedpayments we are able to make is limited pursuant to various baskets ascalculated pursuant to the credit agreement and indentures.

 

The agreements governingour ABL facility generally permit the making of distributions and certain otherrestricted payments so long as borrowing availability under the facility equalsor exceeds $60.0 million. If borrowing availability falls below this amount, wemay nevertheless make restricted payments to Sally Beauty in the aggregatesince the date of the Separation Transactions, together with the aggregate cashamounts paid in acquisitions since said date, of not greater than $50.0million, together with certain other exceptions.  As of March 31, 2010, borrowing availabilityunder the ABL facility exceeded $60.0 million. As of March 31, 2010, the net assets of the Company and its consolidatedsubsidiaries that were unrestricted from transfer under our credit arrangementstotaled $262.6 million, subject to certain adjustments. The ABL facility andthe senior term loan facilities, as well as the Company’s 9.25% Senior Notesindenture and its 10.5% Senior Subordinated Notes indenture contain customarycross-default and/or cross-acceleration provisions.

 

48

----

Tableof Contents

 

On December 16, 2009, theCompany acquired Sinelco, a wholesale distributor of professional beautyproducts based in Ronse, Belgium, for approximately €25.5 million(approximately $37.1 million). Sinelco serves over 1,500 customers through aproduct catalog and website and has sales throughout Europe. Goodwill of $17.6million was recorded as a result of this acquisition. In addition, during thesix months ended March 31, 2010, the Company completed several otherindividually immaterial acquisitions at an aggregate cost of $5.5 million andrecorded goodwill in the amount of $3.2 million. We funded these acquisitionswith cash from operations and borrowings under our ABL facility. Suchborrowings were repaid on or before March 31, 2010.

 

Our primary source ofcash has been from funds provided by operating activities and borrowings underour ABL facility for the six months ended March 31, 2010 and 2009.Historically, our primary use of cash has been for acquisitions, capitalexpenditures and repayments of debt. The following table shows our sources anduses of funds for the six months ended March 31, 2010 and 2009 (in thousands):

 
| ** **                                                     | ** ** | **Six Months  Ended****March 31,** | ** **                                              |
|----------------------------------------------------------------|------------|------------------------------------|---------------------------------------------------------|
| ** **                                                     | ** ** | **2010**                           | ** **                                              | **2009** | ** ** |
| Net cash provided by  operating activities                     |       | $                                  |          92,936 |   | $ |      124,584 |   |
| Net cash used by investing  activities                         |       | (58,044                            | )                                                       | (18,710 | ) |
| Net cash used by financing  activities                         |       | (51,188                            | )                                                       | (100,215 | ) |
| Effect of foreign exchange  rates on cash and cash equivalents |       | (731                               | )                                                       | (769 | ) |
| Net (decrease) increase in  cash and cash equivalents          |       | $                                  |    (17,027                                    | ) | $ |         4,890 |   |

###  

### *Net Cash Provided by Operating Activities*

###  

Net cash provided byoperating activities (which excludes cash used for acquisitions completedduring the period) during the six months ended March 31, 2010 decreased by$31.6 million to $92.9 million compared to $124.6 million during the six monthsended March 31, 2009. The decrease was primarily due to changes in inventorylevels of approximately $50.3 million (mainly resulting from reductions ininventory levels in the six months ended March 31, 2009) and in accountspayable and accrued expenses of approximately $9.3 million, partially offset bychanges in trade accounts receivable of $2.0 million and in other liabilitiesof $6.6 million. This decrease is also net of an improvement in earnings ofapproximately $20.3 million for the six months ended March 31, 2010 compared tothe six months ended March 31, 2009.

 

### *NetCash Used by Investing Activities*

###  

Net cash used byinvesting activities during the six months ended March 31, 2010 increased by$39.3 million to $58.0 million compared to $18.7 million during the six monthsended March 31, 2009.  This increase wasdue to an increase of $32.9 million in cash used for acquisitions, net of cashacquired, and a $6.4 million increase in capital expenditures (primarily as aresult of more store openings) for the six months ended March 31, 2010 comparedto the six months ended March 31, 2009.

 

### *NetCash Used by Financing Activities*

###  

# **Net cash used by financing activities during the sixmonths ended March 31, 2010 decreased by $49.0 million to cash used of $51.2 millioncompared to $100.2 million during the six months ended March 31, 2009.  The decrease was primarily due to netrepayments of debt of $51.5 million during the six months ended March 31, 2010compared to $98.4 million (including $75 million of borrowings under our ABLfacility) during the six months ended March 31, 2009.**

# ** **

# **Capital Requirements**

# ** **

During the six monthsended March 31, 2010, capital expenditures were $23.2 million. For fiscal year2010, we anticipate total capital expenditures in the range of approximately$45.0 million to $50.0 million, excluding acquisitions. We expect that capitalexpenditures will be primarily for the addition of new stores and theremodeling, expansion and/or relocation of existing stores in the ordinarycourse of our business as well as certain corporate projects.

 

## **ContractualObligations**

##  

There have been nomaterial changes outside the ordinary course of business in any of ourcontractual obligations since September 30, 2009.

 

49

----

## **Table of Contents**

 

## **Off-BalanceSheet Financing Arrangements**

##  

At March 31, 2010 and September30, 2009, we had no off-balance sheet financing arrangements other thanoperating leases incurred in the ordinary course of business, as well asoutstanding letters of credit related to inventory purchases and self insuranceprograms. Such letters of credit totaled $14.3 million and $13.4 million at March31, 2010 and September 30, 2009, respectively.

 

## **Inflation**

##  

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

 

## **CriticalAccounting Policies and Estimates**

##  

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

 

Our critical accountingpolicies, as described in our Annual Report on Form 10-K for the fiscal yearended September 30, 2009, include but are not limited to the valuation ofinventories, vendor concessions, retention of risk, income taxes, long-livedassets impairment assessment, share-based payments and related partytransactions. There have been no material changes to our critical accountingpolicies, estimates or assumptions since September 30, 2009.

 

As required by ASC 815,*Derivatives and Hedging*, as amended, the Company recordsall derivative instruments on its balance sheet at fair value.  The accounting for changes in the fair valueof derivative instruments depends on the intended use of the derivative,whether the Company has elected to designate a derivative instrument in ahedging relationship and apply hedge accounting and whether the hedgingrelationship has satisfied the criteria necessary to apply hedge accounting.Derivative instruments designated and qualifying as a hedge of the exposure tovariability in expected future cash flows, or other types of forecastedtransactions, are considered cash flow hedges. Hedge accounting generallyprovides for the matching of the timing of gain or loss recognition on thehedging instrument with the recognition of the impact on earnings of the hedgedtransaction or transactions. The Company may from time to time enter intoderivative contracts that are intended to hedge certain economic risks eventhough hedge accounting does not apply or the Company elects not to apply hedgeaccounting to such derivative contracts.

 

In the fiscal year 2009,the Company adopted the provisions of ASC 820 as it relates to its financialinstruments.  ASC 820, as amended,establishes a three-level hierarchy for measuring fair value and requires anentity to maximize the use of observable inputs and minimize the use ofunobservable inputs when measuring fair value. This valuation hierarchy isbased upon the transparency of inputs to the valuation of an asset or liabilityon the measurement date.  The threelevels of that hierarchy are defined as follows:

 

Level1 - Unadjustedquoted prices in active markets for identical assets or liabilities;

 

Level2 - Unadjustedquoted prices in active markets for similar assets or liabilities; orunadjusted quoted prices for identical or similar assets or liabilities inmarkets that are not active; or inputs other than quoted prices that are observablefor the asset or liability; or inputs that are derived principally from orcorroborated by observable market data; and

 

Level3 - Unobservableinputs for the asset or liability

 

50

----

Table ofContents

 

The Company measurescertain financial instruments at fair value on a recurring basis, includinginterest rate swaps and foreign currency options. In accordance with ASC 820,the Company categorized certain of its financial assets and liabilities basedon priority of the inputs to the valuation technique for the instruments, asfollows (in thousands):

 
| ** **                     | ** ** | **As of  March 31, 2010** | ** ** |
|--------------------------------|------------|---------------------------|------------|
| ** **                     | ** ** | **Total**                 | ** ** | **Level 1** | ** ** | **Level 2** | ** ** | **Level 3** | ** ** |
| Assets                         |       |                      |       |   |   |   |   |   |   |
| Foreign currency options (b)   |       | $                         | 383        |   |   |   | $ | 383 |   |   |   |
| Total assets                   |       | $                         | 383        |   |   |   | $ | 383 |   |   |   |
|                           |       |                      |       |   |   |   |   |   |   |
| Liabilities                    |       |                      |       |   |   |   |   |   |   |
| Long-term debt (a)             |       | $                         | 1,675,311  |   | $ | 755,550 |   | $ | 919,761 |   |   |   |
| Hedged interest rate swaps (b) |       | 15,104                    |       | — |   | 15,104 |   |   |   |
| Total liabilities              |       | $                         | 1,690,415  |   | $ | 755,550 |   | $ | 934,865 |   |   |   |

 

----

(a)          Long-term debt, which is carried at amortized cost inthe Company’s financial statements, is valued using internal models based onmarket observable inputs, except for the senior and senior subordinated notes.The senior and senior subordinated notes are valued using quoted market pricesfor such debt securities.

(b)         Interest rate swaps and foreign currency options arevalued using internal models based on market observable inputs, includingmarket interest rates and foreign currency exchange rates, as appropriate.Please see Note 7 of the Condensed Notes to Consolidated Financial Statementscontained in Item 1 of this report for more information about the Company’sinterest rate swaps and foreign currency options.

 

**RecentAccounting Pronouncements**

 

In December 2007, theFASB revised the accounting standards for business combinations. This newstandard (currently contained in ASC 805, *Business Combinations*(“ASC805”)), among other things, generally requires that an acquirer recognize theassets acquired and liabilities assumed measured at their “full fair values” onthe acquisition date. This practice replaced the practice, under predecessoraccounting standards, of allocating the cost of an acquisition to theindividual assets acquired and liabilities assumed based on their relativeestimated fair values.  This new standardfurther requires that acquisition-related costs be recognized separately fromthe related acquisition. The Company adopted this standard during the firstquarter of the fiscal year 2010. Selling, general and administrative expensesfor the six months ended March 31, 2010 includes approximately $0.5 million ofexpenses related to acquisitions.

 

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

##### *** ***

In August 2009, the FASBissued ASU No. 2009-05 which amended ASC 820 as it relates to the measurementof liabilities at fair value, effective for interim reporting periods beginningafter August 26, 2009. More specifically, this amendment provided clarificationfor liabilities in which a quoted price in an active market for an identicalliability is not available. The Company adopted this amendment during the firstquarter of the fiscal year 2010 and its adoption did not have a material effecton the Company’s consolidated financial position, results of operations or cashflows.

 

##### ***In January 2010, the FASB issuedASU No. 2010-06 which amended ASC 820 as it relates to certain disclosures offair value measurements. This amendment requires, among other things, (a) disclosureof the sensitivity of an entity’s fair value measurements using Level 3 inputsto changes in such inputs, (b) a reconciliation of changes in such fair valuemeasurements and (c) disclosure of transfers between fair value measurementsusing Level 1 and 2 inputs, if any. The Company adopted this amendment duringthe***second quarter of the fiscal year 2010 and its adoption did not have a material effect on the Company’sconsolidated financial position, results ofoperations or cash flows.

 

51

----

Tableof Contents

 

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

 

** Item 3.  Quantitative and Qualitative Disclosures AboutMarket Risk.**

# ** **

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

 

## **Foreigncurrency exchange rate risk**

##  

We are exposed topotential gains or losses from foreign currency fluctuations affecting netinvestments and earnings denominated in foreign currencies. Our primaryexposures are to changes in exchange rates for the U.S. dollar versus theBritish pound sterling, the Canadian dollar, the Euro, the Chilean peso, andthe Mexican peso. Our various foreign currency exposures at times offset eachother providing a natural hedge against foreign currency risk. For fiscal year2009, 2008 and 2007, approximately 16%, 18% and 16%, respectively, of our saleswere made in currencies other than the U.S. dollar. Consolidated net sales forthe six months ended March 31, 2010 reflect approximately $20.7 million inpositive impact from changes in foreign currency exchange rates. In addition,for the six months ended March 31, 2010, other comprehensive income reflects$7.7 million in foreign currency translation adjustments. Fluctuations in theU.S. dollar exchange rates did not otherwise have a material effect on ourconsolidated financial condition and consolidated results of operations.

 

As a result of theCompany’s acquisition of Sinelco on December 16, 2009, the Company, throughSinelco, uses foreign currency options to manage its exposure to certainforeign currencies in connection with Sinelco’s purchases of merchandise. Theseforeign currency option agreements are not designated as hedges and do not meetthe hedge accounting requirements of ASC 815. Accordingly, thechanges in fair value of these derivative instruments (which are adjustedquarterly) are recorded in selling, general and administrative expenses in ourconsolidated statements of earnings. Selling, general and administrativeexpenses are net of non-cash income of $0.3 millionof marked-to-market adjustments related to these foreigncurrency options for the three and six months ended March 31, 2010. Duringthe six months ended March 31, 2010, these derivative instruments did not havea material impact in results of operations or cash flows.

 

A 10% increase ordecrease in the exchange rates for the U.S. dollar versus the foreigncurrencies to which we have exposure would have impacted consolidated net salesby approximately 1.7% in the six monthsended March 31, 2010 and would have impacted consolidatednet assets by 2.5% at March 31, 2010.

 

## **Interestrate risk**

##  

As a result of the debtfinancing incurred in connection with the Separation Transactions, we aresubject to interest rate market risk in connection with our long-term debt. Theprincipal interest rate exposure relates to amounts borrowed under the termloans and the ABL facility. Based on the approximately $918.6 million ofaggregate borrowings under the Company’s term loans and the ABL facility as of March31, 2010, a change in the estimated interest rate up or down by 1/8% wouldincrease or decrease earnings before provision for income taxes byapproximately $1.1 million on an annual basis, without considering the effectof any interest rate swap agreements we may have from time to time.

 

We and certain of oursubsidiaries are sensitive to interest rate fluctuations. In order to enhanceour ability to manage risk relating to cash flow and interest rate exposure, weand/or our other subsidiaries who are borrowers under the ABL facility may fromtime to time enter into and maintain derivative instruments, such as interestrate swap agreements, for periods consistent with the related underlying exposures.We do not purchase or hold any derivative instruments for speculative ortrading purposes.

 

In November2006, we entered into four interest rate swap agreements with an aggregatenotional amount of $500 million. Interest rate swapagreements with an aggregate notional amount of $150 million expired in November2008 and agreements with a notional amount of $350 million expired in November 2009.These interest rate swap agreements did not qualify ashedges and, therefore, the change in the fair value of these agreements, whichwere adjusted quarterly, were recorded in net interest expense in the Company’sresults of operations.

 

52

----

Tableof Contents

 

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

 

**Credit risk**

 

We are exposed to creditrisk on certain assets, primarily cash equivalents, short-term investments andaccounts receivable. We believe that the credit risk associated with cashequivalents and short-term investments, if any, is largely mitigated by ourpolicy of investing in a diversified portfolio of securities with high creditratings.

 

We provide credit tocustomers in the ordinary course of business and perform ongoing creditevaluations. We believe that our exposure to concentrations of credit risk withrespect to trade receivables is largely mitigated by our broad customer base.We believe our allowance for doubtful accounts is sufficient to cover customercredit risks.

 

**Item 4.  Controls and Procedures.**

# ** **

*Controls Evaluation and Related CEOand CFO Certifications.*  Our management, with theparticipation of our principal executive officer (“CEO”) and principalfinancial officer (“CFO”), conducted an evaluation of the effectiveness of thedesign and operation of our disclosure controls and procedures as of the end ofthe period covered by this report. The controls evaluation was conducted by ourDisclosure Committee, comprised of senior representatives from our finance,accounting, internal audit, and legal departments under the supervision of ourCEO.

 

Certifications of our CEO and our CFO, which arerequired in accordance with Rule 13a-14 of the Exchange Act, are attached as exhibitsto this report. This “Controls and Procedures” section includes the informationconcerning the controls evaluation referred to in the certifications and itshould be read in conjunction with the certifications for a more completeunderstanding of the topics presented.

 

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

 

*Conclusions regarding DisclosureControls.*  Based on the required evaluation of ourdisclosure controls and procedures, our CEO and CFO have concluded that, as of March31, 2010, we maintain disclosure controls and procedures that are effective inproviding reasonable assurance that information required to be disclosed by usin the reports that we file or submit under the Exchange Act is recorded,processed, summarized and reported within the time periods specified in the SEC’srules and forms, and that such information is accumulated and communicated toour management, including our CEO and CFO, as appropriate to allow timelydecisions regarding required disclosure.

 

53

----

Tableof Contents

 

*Changesin Internal Control over Financial Reporting.*  During our last fiscal quarter, there havebeen no changes in our internal control over financial reporting identified inconnection with the evaluation described above that have materially affected,or are reasonably likely to materially affect, our internal control overfinancial reporting.

 

54

----

**Table of Contents**

 

**PART II — OTHER INFORMATION**

** **

**Item 1.  Legal Proceedings.**

# ** **

There were no materiallegal proceedings pending against us or our subsidiaries as of March 31,2010. We are involved in various claims and lawsuits incidental to the conductof our business in the ordinary course. We carry insurance coverage in suchamounts in excess of our self-insured retention as we believe to be reasonableunder the circumstances and that may or may not cover any or all of ourliabilities in respect of claims and lawsuits. We do not believe that theultimate resolution of these matters will have a material adverse impact on ourconsolidated financial position, cash flows or results of operations.

 

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

 

On February 25, 2008, Sally Beautydisclosed 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 California in andfor the County of San Diego — Central Division naming, among others, SD Hair,Ltd. and Hair of Nevada, LLC (collectively, “SD Hair”), franchisees of oursubsidiary Armstrong McCall division (“AMLP”) of our BSG business unit, asdefendants.  The suit alleged, among other things, that SD Hair breachedits franchise agreement with AMLP by diverting (selling) Matrix brandedproducts to unauthorized buyers, and that L’Oreal is entitled to make claimsagainst SD Hair under the franchise agreement as a third-party beneficiary ofthat agreement.  On March 24, 2008, SD Hair filed a cross-complaintin the same case naming AMLP and BSG as cross-defendants, seeking, among otherthings, i) declaratory relief from BSG and AMLP in the form of a judicialfinding that SD Hair is not in breach of its franchise agreement and that L’Orealhas no rights as a third-party beneficiary to SD Hair’s franchise agreement,and ii) injunctive relief in the form of a judicial order compelling AMLP andBSG to take appropriate legal action against L’Oreal to enforce SD Hair’sclaimed rights under AMLP’s Matrix distribution agreement.  We haveanswered the cross-complaint and the lawsuit has been set for a jury trial in June of2010.

# ** **

On July 30, 2009,Sally Beauty disclosed in a Current Report on Form 8-K that L’Oreal fileda Second Amended Complaint in connection with the previously disclosed lawsuitdescribed above.  The Second AmendedComplaint alleges, among other things, that AMLP, certain ofits employees and others were involved in selling Matrix branded productsto unauthorized buyers and that certain of its employees (and others) engagedin improper business transactions for personal benefit during 2005 through2007.  L’Oreal seeks money damages,certain injunctive relief and a declaration that L’Oreal is entitled toterminate the 1981 Matrix Distributor Agreement now in effect between L’Orealand AMLP.  None of the employees involvedin the allegations are executive officers of the Company or Sally Beauty.  Substantially all of these allegations weremade known by L’Oreal to Sally Beauty prior to the filing of the SecondAmended Complaint.   L’Oreal alsoprovided Sally Beauty with documents allegedly supporting the allegations.

 

## **As a result of these allegations made by L’Oreal, many ofwhich are incorporated into the Second Amended Complaint, the Audit Committeeof the Board of Directors of Sally Beauty engaged independent special counselto investigate whether certain employees engaged in improper businesstransactions for personal benefit.  Afterextensive review, the Audit Committee and independent special counsel foundinsufficient evidence to support a conclusion that employees of the Company orSally Beauty entered into improper transactions for personal benefit.**

##  

## **On September 8, 2009, AMLP and BSG filed a cross-complaint againstL’Oreal.  In the cross-complaint, AMLP and BSG allege that L’Oreal doesnot have a genuine interest in stopping diversion, and that L’Oreal’santi-diversion policies have been discriminatorily applied to AMLPand BSG.  AMLP further alleges that L’Oreal is using diversion as apretext to attempt to terminate the Distributor Agreement with AMLP.**

##  

**Items 1A.  Risk Factors.**

# ** **

## **In addition to the other information setforth in this report, you should carefully consider the factors contained in Part I,Item 1A. “Risk Factors” in our Annual Report on Form 10-K for the fiscalyear ended September 30, 2009, which could materially affect our business,financial condition or future results. There have been no material changes from the risk factors disclosed inour Annual Report.  The risks describedin that report are not the only risks facing our company.**

 

55

----

Table of Contents

 

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

# ** **

(a) Not applicable

 

(b) Not applicable

 

(c) Not applicable

 

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

# ** **

Not applicable

 

**Item 4.  Submission of Matters to a Vote of Security Holders.**

# ** **

Not applicable

 

**Item 5.  Other Information.**

# ** **

(a) Not applicable

 

(b) Notapplicable

 

56

----

Table of Contents

 

**Item 6. Exhibits**

 
| **Exhibit No.** | ** ** | **Description**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           |
|----------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 2.1                  |       | Investment Agreement, dated as of June 19, 2006, among  Alberto-Culver Company, New Aristotle Company, Sally Holdings, Inc., New  Sally Holdings, Inc. and CDRS Acquisition LLC, which is incorporated  herein by reference from Exhibit 2.1 to Amendment No. 3 to the  Registration Statement on Form S-4 of New Sally Holdings, Inc.  (File No. 333-136259) filed on October 10, 2006†                                                                |
|                 |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |
| 2.2                  |       | First Amendment to the Investment Agreement, dated as of  October 3, 2006, among Alberto-Culver Company, New Aristotle Company,  Sally Holdings, Inc., New Sally Holdings, Inc. and CDRS Acquisition  LLC, which is incorporated herein by reference from Exhibit 2.2 to  Amendment No. 3 to the Registration Statement on Form S-4 of New Sally  Holdings, Inc. (File No. 333-136259) filed on October 10,  2006†                                      |
|                 |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |
| 2.3                  |       | Second Amendment to the Investment Agreement, dated as of  October 26, 2006, among Alberto-Culver Company, New Aristotle Company,  Sally Holdings, Inc., New Sally Holdings, Inc. and CDRS Acquisition  LLC, which is incorporated herein by reference from Exhibit 2.02 to the  Current Report on Form 8-K of New Sally Holdings, Inc. filed on  October 30, 2006†                                                                                               |
| ** **           | ** ** | ** **                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |
| 2.4                  |       | Separation Agreement, dated as of June 19, 2006, among  Alberto-Culver Company, Sally Holdings, Inc., New Sally  Holdings, Inc. and New Aristotle Holdings, Inc., which is  incorporated herein by reference from Exhibit 2.3 to Amendment  No. 3 to the Registration Statement on Form S-4 of New Sally  Holdings, Inc. (File No. 333-136259) filed on October 10, 2006†                                                                          |
|                 |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |
| 2.5                  |       | First Amendment to the Separation Agreement, dated as of  October 3, 2006, among Alberto-Culver Company, Sally  Holdings, Inc., New Sally Holdings, Inc. and New Aristotle  Holdings, Inc., which is incorporated herein by reference from Exhibit 2.4  to Amendment No. 3 to the Registration Statement on Form S-4 of New  Sally Holdings, Inc. (File No. 333-136259) filed on  October 10, 2006†                                                |
|                 |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |
| 2.6                  |       | Second Amendment to the Separation Agreement, dated as of  October 26, 2006, among Alberto-Culver Company, Sally  Holdings, Inc., New Sally Holdings, Inc. and New Aristotle  Holdings, Inc., which is incorporated herein by reference from  Exhibit 2.01 to the Current Report on Form 8-K of New Sally  Holdings, Inc. filed on October 30, 2006†                                                                                                         |
|                 |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |
| 2.7                  |       | Agreement and Plan of Merger by and among Beauty Systems Group LLC,  Lady Lynn Enterprises, Inc., Schoeneman Beauty Supply, Inc., the  Shareholders and F. Dale Schoeneman, dated September 30, 2009†                                                                                                                                                                                                                                                                                 |
|                 |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |
| 3.1                  |       | Certificate of Formation of Sally Holdings LLC, which is incorporated  herein by reference from Exhibit 3.1 to the Registration Statement on  Form S-4 (File No. 333-144427) of Sally Holdings LLC and Sally  Capital Inc. filed on July 9, 2007                                                                                                                                                                                                                                      |
|                 |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |
| 3.2                  |       | Limited Liability Company Agreement of Sally Holdings LLC, which is  incorporated herein by reference from Exhibit 3.2  to the Registration Statement on  Form S-4 (File No. 333-144427) of Sally Holdings LLC and Sally  Capital Inc. filed on July 9, 2007                                                                                                                                                                                                                     |
|                 |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |
| 4.1                  |       | Stockholders Agreement, dated as of November 16, 2006, by and  among Sally Beauty Holdings, Inc., CDRS Acquisition LLC, CD&R  Parallel Fund VII, L.P. and the other stockholders party thereto, which is  incorporated herein by reference from Exhibit 4.8 to the Current Report  on Form 8-K of Sally Beauty Holdings, Inc. filed on November 22,  2006                                                                                                               |
|                 |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |
| 4.2                  |       | First Amendment to the Stockholders Agreement, dated as of  December 13, 2006, between Sally Beauty Holdings, Inc., CDRS  Acquisition LLC and Carol L. Bernick, as representative of the other  stockholders, which is incorporated herein by reference from Exhibit 4.2  to the Annual Report on Form 10-K of Sally Beauty Holdings, Inc.  filed on December 22, 2006                                                                                                      |
|                 |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |
| 4.3                  |       | Indenture, dated as of November 16, 2006, by and among Sally  Holdings LLC and Sally Capital Inc., as Co-Issuers, the Subsidiary Guarantors  from time to time parties thereto, and Wells Fargo Bank, National  Association, as Trustee, governing the 9.25% Senior Notes due 2014, which is  incorporated herein by reference from Exhibit 4.1 to the Current Report  on Form 8-K of Sally Beauty Holdings, Inc. filed on  November 22, 2006                                    |
|                 |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |
| 4.4                  |       | First Supplemental Indenture, dated as of May 30, 2007, by and  among Sally Holdings LLC and Sally Capital Inc., as co-Issuers, the  Subsidiary Guarantors named therein, and Wells Fargo Bank, National Association,  as trustee, governing the 9.25% Senior Notes due 2014, which is incorporated  herein by reference from Exhibit 4.2 from the Registration Statement on  Form S-4 (File No. 333-144427) of Sally Holdings LLC and Sally  Capital Inc. filed on July 9, 2007 |

 

57

----

Table of Contents

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

 

58

----

Table of Contents

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

 

----

* Included herewith

†Certain schedules and exhibits have been omittedpursuant to Item 601(b)(2) of Regulation S-K.  The Company agrees to furnish supplementallyto the Securities and Exchange Commission a copy of any omitted schedule orexhibit upon request.

 

59

----

Table of Contents

 

**SIGNATURES**

 

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

 

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

 

60

----