Sally Beauty Holdings, Inc. (SBH) Q3 2019 Earnings Report, Transcript and Summary

Ladies and gentlemen, thank you for standing by and welcome to the Sally Beauty Holdings’ Third Quarter Results Conference Call. At this time all lines are in a listen-only mode. Later, we will conduct a question-and-answer session instructions will be given to you at that time. [Operator Instructions] And as a reminder, today's conference call is being recorded. I'd now like to turn the conference over to Mr. Jeff Harkins. Please go ahead.

Thank you. Good morning everyone and welcome to the Sally Beauty Holdings’ third quarter earnings conference call. Before we begin, I want to point out to you that we've made a supplemental slide presentation available for today's call that can be viewed from the link provided on our investor site at sallybeautyholdings.com/investors-relations. These slides will follow along our earnings discussion today. In addition, I would like to remind you that certain comments including matters such as forecasted financial information, contracts or business and trend information made during this call may contain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Many of these forward-looking statements can be identified by the use of words such as believe, project, expect, can, may, estimate, should, plan, target, intend, could, will, would, anticipate, potential, confident, optimistic and similar words or phrases. These statements are subject to a number of factors that could cause actual results to differ materially from expectations. Those factors are described in Sally Beauty Holdings filings with the Securities and Exchange Commission, including its most recent Annual Report on Form 10-K. The company does not undertake any obligation to publicly update or revise its forward-looking statements. The company has provided a detailed explanation and reconciliations of its adjusting items and non-GAAP financial measures in its earnings press release and on its website. With me on the call today are Chris Brickman, President and Chief Executive Officer; and Aaron Alt, Chief Financial Officer and President of Sally Beauty Supply. Chris will offer some thoughts on our strategic positioning and giving an update on our transformation efforts. Aaron will then discuss our third quarter consolidated and segment financial results, touching our supply chain modernization and then comment on our efforts for the rest of the year. Now, I'd like to turn the call over to Chris.

Thank you, Jeff, and good morning everyone. I am pleased with our results for the third quarter and we are tracking nicely against a significant change agenda and our goals for the year. The team delivered positive same store sales from Beauty Systems Group for the first time in seven quarters, despite some lingering vendor supply chain issues, which resulted in positive same-store sales for the consolidated enterprise. We also delivered flat gross margins as compared to the prior year and we delivered significantly lower SG&A expenses driven by our cost savings efforts. This translated into an expansion in operating margin versus prior year and a beat to consensus on both reported and adjusted EPS. We started out this fiscal year with an aggressive transformation plan and an extensive list of projects and initiatives to be completed. Significant work remains but we are starting to see the benefit of our efforts and I'm extremely proud of the entire Sally Beauty Holdings team. Q3 was a successful quarter and we are pleased with both the financial results and our operational progress. Before I address specific transformation efforts, I'm going to take a step back for a few minutes and spend some time discussing the strengths of SBH and why we are different. First, from a product offering standpoint, we have a differentiated industry position centered around hair color and hair care. Hair color and care make up over 50% of the sales for Sally and over 70% of the sales for BSG. That represents approximately $1.9 billion of annual sales from our U.S. operations. We're not trying to be all things to all people in beauty or in retail in general. We are laser focused on winning in hair color and care. It is not widely understood that our $1.9 billion of sales of hair color and hair care in the U.S. equals the hair color and hair care sales in these same categories of the entire grocery and food competitive set, tracked by a commonly used industry data source, which contains approximately 35,000 locations or nine times our U.S. footprint. Similarly, our U.S. sales in color and care are just below the $2.3 billion in sales in the same category of the entire drug channel, which has 42,000 locations or 10 times the number of locations compared to our U.S. footprint. If we refine the data further to just hair color, what we see is that our U.S. sales in the hair color category are approximately 1.5 times, the combined sales of hair color or both food and drugs. This data speaks to our concentrated market share and relative strength in our core categories. Second, we realized that it is not enough to have sales. The best sales are differentiated sales. That is why we often point to our differentiated own branded exclusive brand portfolio within our core categories. These brands are sold only at our stores and represent a significant source of differentiation for both of our core business units. Owned and exclusive brand penetration for Sally in Q3 was 44% with approximately two thirds of those sales being higher margin owned brands. Our number one color brand is our own brand Ion. BSG’s owned and exclusive brand penetration is about 53% with almost all of it coming from exclusive brands, which are subject to exclusive distribution agreement. Third, we sell these brands through a continent-spanning industry leading network of stores. We have over 4,000 stores in the U.S. and Canada. We have over 5,000 stores in 12 countries. We don't have the regional fragmentation of the drug chains or the food retailers. Sally has a thousand more store locations than target and BSG has twice as many stores as its next closest competitor, SalonCentric. This is important because our national reach puts us closer to the consumer and closer to the stylist than any other chain. It also means that any color or care brand that wants to leave us for other pastures will face the prospect of being discontinued across our full distribution network if we are unhappy with their strategy. Fourth, we don't just sell hair color and hair care. Our team is a community of early adopters and users who offer advice on the product and its application. The SBH team is a competitive advantage. We have over 22,000 sales professionals worldwide. Many of them are hair color and care experts for both the DIY consumer and the professional stylist. In the Sally U.S. and Canadian business, over half of our 18,000 associates have been trained and are certified in advanced color. In addition, it is also common in both Sally and BSG stores to be helped by an associate or store manager who is also a trained cosmetologist. You would be hard-pressed to find that level of help or product knowledge at Walmart, Target or Amazon. At BSG, we have a strong education team that partners with our brands at over 10 national trade shows each year and over 1,200 in-salon and in-store education events per year in helping stylists with the latest innovations and hair coloring techniques. This is not something you get at the competition, and it helps to make our consumers sticky. Fifth, our company possesses strong gross margin and generates substantial free cash flow. After investing in our business, our free cash flow gives us great flexibility in terms of making acquisitions, reducing our debt levels, returning capital to shareholders, or any combination of the above. And, finally, our business has proven to be resilient in recessionary cycles, such as the 2008 downturn. There is a natural hedge that exists between the two segments as the economy shifts up and down throughout its cycle. So why have I spent so much time talking about the foundational assets within Sally Beauty Holdings and not just the quarterly results? Because as you assess SBH, you have to understand the assets we are starting with to really appreciate the benefits of our transformational efforts. It is no secret that both the retail and beauty sector have changed significantly over the last several years. Competition has increased, and other retailers have leveraged the beauty category to drive traffic to their stores. This led to increased investments in stores and the customer experience, with revamped beauty sections, in companies like Target, Walgreens and CVS. The consumer has come to expect more than shelves with product. In addition, customers have gone digital and have become accustomed to the options of an omnichannel shopping experience, while the retailers have installed technology to help them better manage their supply chain, their stores and their customer relationships. And, finally, all retailers are feeling the pinch of higher labor costs and a tired job market for top talent. We knew we had to respond, and our transformation plan all along has been to build up our highly-differentiated position in color and care, but enable and extend that category leadership with a modern digital platform, a high-performing supply chain, modernized loyalty and marketing programs, innovative new brands that speak to a younger consumer, and an even better store team and store experience. What is exciting is that we are now at the inflection point, and many of these initiatives are now positively impacting our customer experience. We expect this momentum will continue to build as we execute on our key transformation initiatives and create additional value for customers, extending our already substantial lead in our core categories. Our transformation initiatives have been focused around four key pillars: playing to win with our customers, with a focus on our differentiated core of hair color and care; improving our retail fundamentals; advancing our digital commerce capabilities; and continuing to drive costs out of the business. We have made significant progress on our plans, and I will spend a few minutes on each pillar and our recent accomplishments. First, playing to win with our customers. I've already highlighted how Sally is the destination for the DIY and beauty enthusiastic and BSG is the leading destination for licensed stylists. Over the last few quarters, we have launched several key brands within both Sally and BSG, most of which are exclusive to SBH. Those efforts continued in the third quarter and are specifically targeted at driving new traffic and expanding her basket. At Sally, we have targeted three specific types of consumers with our innovations, younger consumers, multicultural consumers, and new private label consumers. Younger consumers are more likely to explore vivid colors. Arctic Fox, Good Dye Young, Iroiro and our expanded Ion Vivid SKUs all appeal to these younger consumers and drive new traffic to our stores. Vivid color sales have grown to 20% of our total color business in the recent quarter, versus 16% in the prior year. Our multicultural consumer has been a historical strength, and we are moving to reinforce that position. We are excited about the recent exclusive launches of My Black Is Beautiful from P&G, All About Curls from Zotos, and now Vernon Francois, an up-and-coming stylist-driven brand from the UK. We have more exciting launches planned, and we intend to have a multicultural hair assortment that cannot be beat. Finally, as we have talked about in the past, we continue to support private label efforts such as the Ion Pro Color kits and other category expansions, such as new Ion clippers and trimmers. Our own brands stand for both quality and value, and we will continue to leverage that positioning at Sally. On the BSG side, our earlier launches of Swedish vegan brand Maria Nila and the Henkel Pravana brand have gone well, and we expect to continue to grow those brands over time. In addition, BSG continued to add to its innovation pipeline by launching two new exclusive brands during the quarter, No Nothing, a hypoallergenic, fragrance-free hair care brand, and Elegance, which expands our men's barbering assortment. We are working on additional new brand launches for BSG in the coming quarters. Next, improving our retail fundamentals. At the end of last year and in the first quarter, we started our digital reinvention by adopting a new CRM platform from Salesforce and launching the Sally Beauty Rewards loyalty program. The new Sally Beauty Rewards program is a free membership where customers earn points towards redeemable cash certificates based on their spend. The transition to the new program continues to go smoothly and at the end of the third quarter, we had over 15.3 million active members. We are starting to see an uptick in the redemption rates from our loyalty customers at Sally, which should help drive traffic over time. Going forward, we will also benefit from a more robust customer data set, which will make it easier to drive traffic through targeted marketing that is designed to fulfill our customers' specific needs. Lastly, we recently completed testing of our new concept stores across our Sally and CosmoProf stores in Las Vegas. Learnings from the test included a better shopping experience and a better understanding of the operating changes necessary to remove friction for our clients. The test stores also included enhanced technology, including a video display behind the cash rack that streamed educational and product content and a consumer-facing technology showing a kiosk within the store housing a built-in iPad that walks the customer through questions about the characteristics of their hair as well as the goals they want to accomplish with their hair color. The kiosk will then make specific color product recommendations and use the iPad camera to create an image of the customer and simulate how the color will appear on the customer. The overall experience is appealing to the younger consumer and will help Sally recruit and engage the next generation of customers. These learnings will be taken to additional markets for both segments, with Sally launching a second market refresh in Charlotte, North Carolina, towards the end of this fiscal year. Moving on to advancing our digital commerce capabilities, the speed of technology change at SBH is considerable, with significant progress being made in Q3. So far this fiscal year, we have launched and have finished or are accelerating our technology evolution across 14 different programs, touching our consumers, our stores and our supply chain. For consumer-facing technology, we implemented new Salesforce CRM and connected it to our loyalty programs and POS so that we can better understand and serve our clients. In Q3, we launched the new Sally app and, as expected, have seen a new, younger client accessing the Sally Beauty assortment and becoming members of the loyalty program. We had more than 255,000 downloads in the first several weeks of service. We rolled out the new Sally website to better serve our digital guests. In Q3, we also made enhancements to the BSG app to remove friction from the buying experience for our professional clients, leading to increased growth. And in Q3, we installed a customer feedback loop with SMG, allowing us to take direct feedback and measure net promoter scores from clients on individual stores and on our digital interactions so that we can drive a better experience. For associate-facing technology, to make our checkout faster and integrated with our digital and loyalty platforms, we have rolled out new POS to more than 600 stores, and we will finish more than 1,400 by the end of September, with the entire U.S.-Canada fleet completed in 2020. In Q3, we implemented the Reflexis workforce management system to provide central visibility to and control over scheduling of store hours to optimize our investment in labor on our sales floors. In Q3, we continued the launch of our new task management technology within the stores to ease fleetwide training, communications and the tracking of completion of enterprise initiatives. For supply chain- and vendor-facing technology, we have launched five elements of our JDA platform – SKU setup, space planning, EDI, demand planning, and perpetual inventory – across the entire fleet. In Q3, we launched the technology work to implement a test of our new order management system. This capability will, over time, open up a full range of client service options, such as buy online, pick up in store; buy online, ship from store; and same day delivery for both Sally and BSG. We are working on a new warehouse management system. We are working on new same-day delivery integrations. And, finally, we have also been working on a European ERP implementation, an enterprise-wide human resource system implementation, and updating the technology backbones of our stores, supply chain buildings and central headquarters. The list alone is impressive. We understand the necessity of being able to match our competitive strengths with our digital capabilities. All of the parts of the digital flywheel are now in progress and gaining momentum. Finally, continuing to drive costs out of the business. Over the last several quarters, we have worked very hard to find efficiencies and savings in how we operate our business. This concludes savings from negotiations with our service provider, more streamlined operations, and better sourcing. This effort has helped us to fund the investments that we have made and have been making over the past year as part of our transformation plan, and this is an ongoing process with additional opportunities already in the works. In summary, so far in fiscal year 2019, we have made significant progress on our transformation plan, focused on building our company into a better-equipped omnichannel retailer and distributor, taking the first steps of modernizing our supply chain to be more efficient and flexible, and shifting our core retail operations away from manual processes to a more technology-enabled, efficient environment. We still have work to do, and our transformation plan will continue into fiscal year 2020 as we refine our marketing and branding, move from a product designer to a product brand builder and continue to refresh our store experience. But we are gaining momentum, and we look forward to adding these new capabilities to our strong and distinctive product assortment and our deep category expertise. Now I will turn it over to Aaron to discuss our results and plans in more detail.

Thank you, Chris, and good morning. I have three objectives today – to review the third quarter consolidated financial details and segment results, to offer an update on our supply chain modernization efforts, and to offer perspective on our full year financial guidance and our capital allocation strategy. We are pleased to see third quarter consolidated same-store sales increase by 0.1%, reflecting a significant change over last year. Consolidated revenue was $975.2 million, a decrease of 2.1% versus the prior year, largely driven by our net closure of 81 stores and an unfavorable impact from foreign exchange translation of 80 basis points. Our global e-commerce business grew by 25.9% versus the prior year. On the top line broadly, our U.S. and Canadian resale business within Sally Beauty continues to demonstrate solid momentum from our transformation efforts, and the Beauty Systems Group clearly made progress. However, we experienced two challenges that impacted our sales results – continued headwinds in Europe and key item inventory issues at both Sally and BSG resulting from both own brand and vendor supply issues. Our consolidated gross margin for the quarter was 49.5%, which was flat compared to the prior year. Increases in our highest margin U.S. and Canadian business of Sally Beauty were somewhat offset from the combination of gross margin challenges in Europe and within Beauty Systems Group. I will comment more on this in the segment results. After excluding charges related to the Company’s transformation efforts in both years and expenses associated with previously disclosed data security incidents in the prior year, SG&A expenses, including depreciation and amortization expense, were $360.2 million in the quarter, a decrease of $10.5 million, or 2.8%, from the prior year. The decrease in SG&A dollar costs represents the continued benefit of our aggressive transformation efforts and tight control over discretionary expenses. As a percentage of sales, SG&A expenses declined 30 basis points to 36.9% compared to the prior year. Adjusted operating earnings and adjusted operating margin were $122 million and 12.5%, respectively, compared to $122.7 million and 12.3%, respectively, in the prior year. Adjusted diluted earnings were $0.60 per share, flat compared to the prior year and a $0.02 beat to consensus for the quarter. The company continues to generate strong cash flow from operations, which was $93.7 million in the quarter. Net payments for capital expenditures in the quarter totaled $20.4 million, which was mainly spent on information technology projects related to the new e-commerce platform, the new point-of-sale system and the JDA merchandising and supply chain platform, as well as store remodels and maintenance. Free cash flow was $73.4 million in the quarter, down $5.6 million, or 7.1%, as compared to the prior year. Additionally, we are very pleased to report that we continue to make progress against our leverage levels. During the third quarter, we paid down our term loan B by more than $116 million and repurchased an additional $4.7 million of our senior notes on the open market. The debt reduction was funded largely by our strong cash flow from operations as well as a small borrowing on our asset-based revolving line of credit, which ended the quarter with an outstanding balance of only $15.5 million. The net reduction on our debt levels totaled just over $1.5 million, and the company’s leverage ratio ended the quarter at 2.69 times. In total, we have reduced our debt levels by over $168 million year-to-date. Turning to segment performance, for the third quarter, global Sally Beauty same-store sales decreased by 0.6%, primarily driven by the European business results, which continue to be challenged by uncertainty surrounding BREXIT, the impact of the consolidation of the continental operations, and key changes to the promotional environment in Europe. By comparison, same-store sales for the U.S. and Canadian business were down only 0.2%. The U.S. and Canadian business represents 78% of the segment sales in the quarter. The Sally segment generated consolidated revenue of $575 million in the quarter, a decrease of 2.8% compared to the prior year, driven primarily by 70 fewer stores, Europe’s continued challenges, and the unfavorable impact of foreign currency translation of approximately 120 basis points. We also continued to make meaningful progress with Sally’s U.S. and Canadian e-commerce business in the quarter, which helped deliver e-commerce revenue growth of more than 32%. As we work through our digital change agenda and refine our tools, we will continue to invest in improvement to the overall online customer experience. Gross margin for this segment improved by 40 basis points in the quarter to 55.8%, with margin expansion in the U.S. and Canada of 80 basis points, partially offset by weakness in Europe. Segment operating earnings were $95.8 million in the quarter, an increase of 0.9% versus the prior year, driven primarily by the gross margin improvements and favorable operating expenses resulting from our cost savings efforts. Segment operating margin improved by 70 basis points to 16.7% as compared to the prior year. Now turning to our Beauty Systems Group segment, we are delighted to report that same-store sales increased by 1.4%, the first positive same-store sales quarter in seven quarters. Net sales were $400.1 million in the quarter, a decrease of 1.1% compared to the prior year, driven primarily by declines in the full-service business and an uptick in supply chain issues that impacted select SKUs from key brands that were out of stock. Foreign currency translation decreased the segment’s revenue growth in the quarter by approximately 30 basis points. The estimated impact from the product supply issues was approximately 70 basis points to both same-store sales and net sales growth. BSG’s gross margin was 40.3% in the quarter, admittedly a decrease of 60 basis points from the prior year, but one which is addressable. BSG’s gross margin decline has been a key focus area for us, and as we stated on the last earnings call, we do not believe the margin decline issues to be structural or industry challenges but, rather, the result of significant change within Sally Beauty Holdings and its merchant and field teams complicated by our need to transition to modern technology and data practices. We are starting to see progress in our efforts to stabilize and improve BSG’s gross margins. This effort will continue in coming quarters. Segment operating earnings for BSG were $61.6 million, down 0.8% from the prior year, driven by lower revenue and gross margin, mostly offset by lower operating expenses from our aggressive transformation efforts. Segment operating margin improved by 10 basis points to 15.4% as compared to the prior year. With the high-level results behind us, I’m now going to provide an update on our supply chain modernization efforts, which have particular relevance to the Beauty Systems Group business. As discussed on our previous earnings call, our supply chain is the product of acquisitions conducted but not rationalized over many years. At the start of the year, we had 15 distribution centers across the United States and Canada. We continue to make fast progress towards a more efficient supply chain network that will become a stronger asset for us going forward. Since our last call, we closed and excited two additional distribution nodes in Marinette, Wisconsin, and Lincoln, Nebraska, both of which serviced Beauty Systems Group. This quick realignment has put pressure on the Beauty Systems Group business, as the team has tied store replenishments and full-service customers to new points of supply. These fast changes will help our cost structure, but there was a modest impact on service levels during the quarter as we work through our aggressive transition. As a result, the company now has 11 distribution centers in its current network covering the U.S. and Canada. And, importantly, we have finalized the negotiation and executed a new lease for our new North Texas distribution node and expect to begin operations for BSG’s store replenishment and e-commerce fulfillment operations by the second quarter of fiscal year 2020. We also continue to make progress on lowering our distribution costs and improving our on-time delivery to stores as a result of new pooling delivery arrangements in key cities like Dallas, Houston, Boston and New York. We now have over 500 stores on the pooling delivery service, and we will double this pooling distribution model to another 500 stores in coming months to cities in California and in Florida. Early indications are showing that the pooling distribution model is also yielding a reduced level of damages that occur in the normal transportation process to stores. Importantly, most of the early benefit of this effort is to the Sally business, with BSG to follow. Now turning to our full year financial guidance, as I look at the business year-to-date, what I see through three quarters is this – consolidated same-store sales are down only 0.1%, which is in line with our full year guidance of approximately flat; consolidated gross margin is 49.2% year-to-date, down 20 basis points, also in line with our full year guidance of approximately flat, with Q3 achieving flat gross margins; adjusted SG&A as a percentage of sales is 37.4%, or flat, to the prior year and modestly ahead of our full year guidance of slightly up; adjusted EPS is $1.68, up 2.4% over the prior year, which is just a touch below our full year guidance of up mid-single digits. We have an aggressive plan for the fourth quarter. We are confident that we are seeing benefits starting to take hold from the many transformation initiatives that are underway. However, we do face continued risk in Europe. It will take us time to realign the Beauty Systems Group margin. And, of course, we must continue to address the natural operational risks from the breadth of our transformation efforts while competing in the marketplace. Nevertheless, we see continued opportunity, particularly within the Sally U.S. and Canada business, our largest business. On the basis of our progress to date and the relative risks and opportunities remaining as we close the year, we are holding our guidance for the full fiscal year 2019. Now our capital allocation strategy. We have consistently said that we will prioritize needed investments in our business that we believe will deliver the greatest value for shareholders, then focus on measured debt repayment to move our leverage ratio closer to 6.5%, as defined by our credit agreement, and then we will consider returning capital to shareholders. We have continued our investments in the business related to our transformation plan and are on track to invest $120 million in capital expenditures during fiscal year 2019. The fourth quarter does have a robust schedule for capital expenditures, including IT projects, the new POS, new warehouse and order management systems, and the refresh of the BSG e-commerce site. I am assured by our teams that we expect to land our capital investment spend as guided. As should be evident from our actions in Q3 in paying down debt, we are committed to achieving reductions in leverage towards the 2.5 times level over time. During the fourth quarter of fiscal year 2019, we will continue to explore efficient opportunities to further reduce our debt levels and associated leverage ratio. In addition, as we compare the combination of the underlying financial strength of our business and our confidence in the progress of our transformation plan to where the stock price resides as of today, in the $12 range, we may also be opportunistic about returning capital to investors through share repurchases. To be clear, we are committed to reducing leverage over time while taking advantage of opportunities presented to us. To that end, we expect our leverage ratio at year-end to be around or below the 2.6 times achieved at the end of Q3, with further progress downward in fiscal 2020. Thank you for your time this morning. Now we would like to turn the call back over to the operator for Chris and I to take your questions.

[Operator Instructions] Our first question will come from the line of Mark Altschwager from Baird. Your line is open.

Great, good morning. Thanks for taking my question and congrats on the continued progress. With respect to the guidance, I think your adjusted operating income dollars year-to-date are down about 4%, which compares to the annual guidance for down slightly. So I know you said you have an aggressive plan for the fourth quarter, but can we imply that your plan for the fourth quarter is for positive operating income growth in order to achieve that full year guidance of down slightly?

The math would certainly seem to indicate that.

Okay, fair enough. And then a couple of questions on BSG. First, can you give us a sense for how much the recent brand wins contributed to the BSG comp growth? And how would you characterize the run rate of these brands versus your expectations longer term?

Yes, I'd say both of the brands are – perhaps Maria Nila is probably a little ahead of our plan, and Pravana is probably – I would describe as on track, as well as the other brands are a little too new to give you a feel for those, so, no, nothing. And Elegance just recently hit the stores, so we'll have to wait and get a better read on those. But I would say they're doing well. We expected that there would be a rebound in the quarter. We did have some ongoing supply chain issues, as I mentioned in my recorded notes. The reality is that those are less than the previous year, but still a negative headwind. But we expect to work through those in coming quarters.

Great. And then secondly, on BSG, it sounds like your full-service business is seeing some pressure. Could you maybe step back and give us a broader sense of the dynamics there? I guess what percentage of BSG does full-service represent today? Where do you see that going over the next two to three years? And what are the initiatives you have in place to make sure that you're capturing that business as it migrates channels?

Yes, we have had some pressure there, specifically around some key brands that as they move more into a retail environment, salons stopped retailing those brands, and what historically happened is they would purchase that product from us and then invest heavily in retail, both online and in their salons. That business has declined. We actually think we're going to be lapping some of the biggest declines here coming in the next few months, so we actually think we should – the declines should slow down significantly, as well as we've actually had some recent brand wins. So our expectation is that we're at the point where that should be stabilizing and that should start growing again over time, but at this point in time, it's been a drag. Aaron, I don't know if you want to add anything to that.

Just that from a relative percentage basis, the full-service business is about 30% of total sales for the segment.

Great, thanks for all the detail. And I will jump back in the queue.

Thank you, Mark.

Thank you. Our next question comes from the line of Rupesh Parikh with Oppenheimer. Your line is open.

Good morning and thanks for taking my question. So on the Sally Beauty Supply side, the trends there still remain sluggish. The U.S. and Canada is doing better. I was just curious, as you look at all the efforts that you've done year-to-date, what do you think are the key efforts that are working and then the efforts that maybe are not working thus far?

Rupesh, is your question just about the U.S.?

Yes, U.S. and Canada. Yes, U.S primarily.

Sure. I would tell you I am really excited about what we're seeing in the U.S. and Canada, notwithstanding the down just a nudge this quarter. This year for us has been about a pretty dramatic reset on the innovation pipeline, making sure we're getting the right product on shelf. It's been about resetting our store operations. It's been about resetting our approach to the marketing program, which I'm very excited about the national launch, which is coming with the new branding. It's been about retraining the team. Really, we've been ripping the business up and re-enabling all the pieces with technology and with best practice. And so as I look at the business, I see a lot of goodness in a lot of places. The quarter for us on the Sally side was driven by a couple things. We had one region which was down, which we are addressing aggressively. We also took a higher accrual relative to the loyalty program at the ramp-up, and then we had some pretty important supply issues within owned brands, our highest velocity Ion items, that we believe has put us where we were from a same-store sales perspective for the quarter. But like I said, I remain confident, and I'm quite pleased with what I'm seeing from the underlying business fundamentals.

Okay, great. And then switching topics, maybe just to some of the market concerns out there just on Amazon's more aggressive entrance on the professional side. Is there any commentary you can provide based on what you guys are seeing in terms of brand overlap and how pricing compares versus Sally on some of the same items?

Happy to, and my encouragement – and I know you've done this work, Rupesh, and my encouragement to everybody is to go to the site, spend time on it and look at the assortments, get behind the gate if you can. I think you'll find it's mostly very similar to what's in front of the gate. But really evaluate the assortment that's there. What we see there is that it's mostly an accumulation of resellers that the pricing is well above wholesale pricing for the most part, and with very spotty inventory supporting it. The other thing we see is that despite two years – almost two years of knocking vendor's door in this channel, it does not appear that they have managed to attract any meaningful partners in the pro vendor community, and that's consistent with the conversations we've had with those pro vendors, who really question whether it's incremental. As you know, recruiting a stylist to a color brand is not something that happens online. It takes training and education. And, therefore, you're really just looking at moving brands – or stylists across channel. You're not really recruiting any incremental stylists. And so there's a real reluctance to disrupt current distribution relationships with no incrementality. And we don’t dismiss Amazon's strengths. They obviously have world-class e-commerce and digital capability. We're coming at this from a different perspective, which is we're taking what is a leading assortment in the category with leading – and market-leading set of stores and capabilities in terms of training and education, as well as our full-service team who reaches out to these stylists daily on a one-on-one basis. And we're building what we believe are world-class e-commerce and digital commerce capabilities on top of that, and what we're really excited about is that because we've been at this for quite a while now, those things are coming to life real-time in our stores and in our network. And in the coming quarters, I think we're going to be able to add really fabulous capabilities in terms of service models and digital capabilities to an existing strength and leadership in the category. So my request of everybody is to move past the hysterics of the announcement, take the time to really dig in on what the assortment is there, and recognize that that's not something that's just a few weeks old, it's years in the making to get to that assortment, and then make your own assessment of whether you think that's a credible assortment to build off of or not. And we're going to keep focused on what we're going to – our strategy, which is to add truly leading-edge capabilities to what we think is a market-leading assortment, a market-leading capability and market-leading expertise in the category.

Okay, great. And just one quick housekeeping question. So, Aaron, for Q4, what's the right way to think about the tax rate?

I would stay with the current guidance. We have a number of one-off items we're watching around the world, which if they play out as they expect we will, we will be consistent with guidance.

Great. Thank you for all the color.

Thank you, Rupesh.

Thank you. Our next question comes from the line of Oliver Chen with Cowen and Company. Your line is open.

Hi, thank you. A modeling question on the gross margins. The gross margin at the Sally side was attractive, but the comparison ahead gets a little bit harder. And then, conversely, at BSG, your gross margin comparison is a little bit easier. What are your thoughts on the dynamics there, and what drove the nice gross margin at the Sally segment? Second, I would love your thoughts, as you do look at net promoter scores, where you see the most opportunity and how that may interplay with long-term traffic trends opportunity across both divisions. Thank you.

Sure. Good morning, Oliver. Let me start with the second question and then come back to the first question. Our ability to assess the customer interaction real-time, both in-store and online, is new to us. It's only in the last couple of months that we've partnered with SMG to get real-time feedback and now be pushing that real-time feedback out to the stores and the teams that are interacting directly with the consumers. We have been very pleased with the MPS results that we're seeing so far. They're early enough that I won't give you a number, but just suffice to say I was pleasantly surprised by how high they were given the amount of change we have underway with our – even with our very loyal customers. So MPS is something that will continue to grow. On the gross margin question, let me attack it this way. The Sally business has seen – the Sally U.S. and Canada business, the largest business we have within the Sally accounting segment, has seen positive progress all year on its gross margin efforts, driven by a couple of things. First, the change to fewer, deeper, bigger from a promotional process and decision-making, we are seeing the benefit relative to promoting where we need to or where we want to invest and not promoting just for the sake of promoting. Our customers have responded favorably to our approach there, though we know we have more to do in some categories around optimizing the mix and timing of our promotions. We have seen benefits in sourcing, which sourcing, which I would tell you, given our need to increase our turns over time, that that's an area where Sally and BSG both will have further gross margin opportunity as we carry forward, as we turn the product that we acquired before the sourcing opportunities occurred. And then we are also attacking each of the elements of our supply chain which contribute to gross margin to find the efficiencies, and you heard me allude to some of those as part of the overall my comments earlier. BSG – so back at Sally for a second, what I would say is the compare does get harder, but we're making good progress, and Sally is in a good position to continue to optimize its gross margin as we carry forward, and that's a key element of why I was willing to hold guidance for the year. On the BSG side of the equation, from a gross margin perspective, what I would say is the story – the elements of the story aren't different, save for there's an element of just business execution rolling through the BSG business that Mark Spinks and the team there are working on as it relates to, again, pricing and promotion, the mix of the product that we have out there. We have some key merchandising fundamental relative to the deals we're striking, relative to how they're rolling through the network. There are some differences between the Canadian business and the U.S. business that we need to reconcile as well. We look at the gross margin opportunity for BSG as complicated but identifiable and actionable, and while it's taking us some time to get there, we're quite pleased with the early results we're seeing, notwithstanding where they landed for the quarter, as a carry-forward. Oliver, did I address every element of the question?

Yes. That’s very helpful. And the last question we had was bigger picture about your thoughts about the younger customer and the rising importance of Generation Z, and perhaps that interplays with your concept stores and what you're thinking about the future of stores. We would love your thoughts on the priorities and strategic product or marketing priorities as they relate to your view of younger customers?

Yes. Oliver, this is one of the exciting things that's going on in our stores right now, and I mentioned it in my comments. The growth of vivids in our stores is spectacular, and we're bringing in a lot of really unique brands in that category that are tied mostly to influencers, and those are bringing a younger consumer in. We're also seeing with the launch of the app – not surprisingly, we've had almost 255,000 downloads of the app already. That's, not surprisingly, skewing towards a younger consumer as well. And so I think we're finding more touch points with the younger consumer, which is great to balance out what you know out what you know has been historically more of a gray coverage customer, especially in color, and tends to skew older. We're now getting the other end of the spectrum into our stores and teaching a much younger consumer that Sally is the place for color. And I think that once we actually add some additional capabilities to the app around the ColorView as well as expand the use of ColorView in our stores, I see a really great opportunity to engage the younger consumer and make us part of a fun thing they can do as they begin to experiment with self-expression.

Thank you. Very helpful. Best regards.

You bet.

Thank you. Our next question comes from Simeon Gutman with Morgan Stanley. Your line is open.

Hi, this is Josh Kamboj on for Simeon. Thank you for taking our questions. I'm just following up on the question earlier acknowledging everything you said about all the progress in the works at Sally Beauty, could you maybe diagnose some of the top-line challenges there at the moment in the U.S.? Without knowing some of the specific numbers for each category, in theory, the box color addition and the removal of the appliances from stores should be additive to the comps, but it looks like you're still below the industry growth rate, so are the core categories struggling to keep up? If so, which ones? Or is there something else going on that's holding back the top-line growth?

Couple of thoughts for you. First, we are very happy with the results in the core categories where we are differentiated, which is color and care, so I would call that out. With respect to the other categories, nail in particular is going well, but we have opportunities in areas which for us are not traffic drivers but are, rather, basket fillers, and that would be areas like skincare and cosmetics. Appliances, if we're talking about hair dryers versus the equipment, that is an area that we pulse in and out of over the course of the year from a focus perspective, heavy for us in Q1, hasn't been as heavy from a focus perspective in the last two quarters there, but we are using it as a category where we can drive traffic and into the basket with the right promotion, consistent with fewer, deeper, bigger. The sales results I would point you to, I think what I would say is while the same-store sales results for Sally were negative for the quarter, part of that is the European business, which we've talked about previously. In the U.S., the two biggest drivers were the fact we were out of stock on some of our highest velocity owned- brand items, and that's on us as we work on some cost of goods initiatives between suppliers, as well as the impact of our redemption rates going up on loyalty, which, at the end of the day, is a good thing. Nevertheless, we took a higher accrual this quarter, which hit both the top line.

All right. Thank you. And then just following up on some of the potential BSG online trends or opportunities, can you talk about where you expect e-commerce as a percentage of sales in BSG and your own business over time? And then just following up to the Amazon comment, acknowledging that they've tried for two years and haven't gained a lot of traction, maybe you can shed some light on how long your exclusive licenses typically last and how often those contracts may or may not be renegotiated?

Yes, so let me hit the second one. They tend to be five-year contracts, but they vary, and there's a range of when they expire. So, I won't get into those details, but they tend to be five years. The reality is that if you look at BSG, I think they're well-positioned here going forward. We're starting to add some of the digital capabilities. We've seen, by the way, terrific growth in BSG on its online platform. We have both portals as well as our own platform, and what we're seeing is that our own platform is accelerating and is now much bigger than our portals that we do for our customers, such as large chains. That being said, we've got more to add, so we've got an update to both the website and the app to make it easier to navigate coming here in the very end of the fourth quarter, and then we're working on new delivery service options that will hit and we'll talk more about as we get into the new fiscal year. So I think there's a great chance for us to layer on top some market-leading service models and really serve stylists in a way that nobody else can touch and continue to grow that digital penetration. So it's in the 3% to 4% range today. We expect it to grow rapidly. I do think our target now is probably in the 10% range, but let's get there, and then we'll worry about bigger from there once we're there.

All right, awesome. Thank you.

Thank you.

Thank you. Our next question comes from the line of Lauren Frasch with Wells Fargo. Your line is open.

Good morning everyone. Could you talk a little bit more about the initiatives at BSG? I know they're meant to be lagging Sally's initiatives for the time being, but so far, what is tracking to or above your plan or might be below expectations? As a quick follow up, it sounds like supply chain changes continue to be a headwind there. How much of those were anticipated in the quarter? And are you planning similar changes in Q4 or beyond that could also pressure the comp? Thank you.

Good morning. Couple of thoughts for you. You’re right to point to the fact that we have been using the Sally Beauty business to be at the vanguard of a lot of the changes we're driving, and that continued to be true this quarter as well, which is not intended to diminish the incredibly hard work that the BSG team is doing but, rather, to reflect the fact that we're picking our spots, leading with one business and then pulling the other parts of the business along as we've tested and seen what works and what doesn't work. For BSG for the quarter, on the supply chain, there were really – to that end, there were really two elements to it. You've heard me talk about the supply chain modernization efforts, and the practical reality is that many of our sub-optimal distribution nodes have been in the BSG business, and we have largely now dealt with that, and so the BSG will be pivoting from going out of – moving out of facilities to getting ready now for the launch both of JDA in one of their buildings but then also, importantly, the North Texas distribution facility, which will lower their cost as well as lower the speed to market for store replenishment as well as their guests. And so that has always been in the plan, that there would be a lot of work there, and when we're working through with them. As I think about the other parts of the program, as we have been re-basing our promotional processes, our merchandising processes as well, Sally is moderately ahead of BSG on those. They're coming down the path. We're excited at what we're seeing. The way I choose to look at it is given the progress that SBH has made over the last three or four quarters, we have a lot of opportunity coming our way as we move into Q4 and into next year, because just as Sally has improved, the pieces that are driving the improvement at BSG are also now known to us and out there, and it's just a matter of us executing on them as we can.

Great. Thank you so much.

Thank you.

Thank you. Our next question will come the line of Olivia Tong with Bank of America. Your line is open.

Thanks, good morning. I think the perspective you provided on your differentiation versus competition during your prepared remarks was super helpful, so I'm just interested in your take as to why you're seeing customers willing to try different channels. I mean, do they just prefer the convenience of being closer to the stores or the convenience of online and it's just that customers don't know what you have in store and you need to step up your marketing, or is there something else that maybe you can point to as to why the consumer is willing to look at alternative channels?

Well, let's separate the two channels and talk about them distinctly, and I'll let Aaron talk about the Sally side. On the BSG side, the reason we've been investing in digital capabilities and now new delivery service models is because we know that our customers get busy and there are peak periods in a stylist's year where it's harder for them to get to the store and restock than other types. And they're going to need same-day delivery in some cases or very rapid delivery and resupply because they're so busy working their salon, they don't have time at the end of the day to go to the store. So that's something we recognize, something we plan on offering them rapid delivery models, including same-day service models, and we've been investing to make that possible. But I don't think that – I think what I like is I like our position of building off a leading assortment that's highly differentiated with a strong store base that we can deliver from, with a strong DSC network and a strong training program that allows our vendors, partners to basically build their brands within our network. Then I think adding those digital capabilities to that strong foundation is a stronger and more credible offering than the reverse, which is to come in with digital capabilities but not the brands and products necessary to compete. Let me turn it over to Aaron a little bit and let him talk about the Sally side.

couple thoughts. First, I think our point of view is the consumer may not differentiate black and white between digital and store platforms, and so it's not unusual to see someone on their phone while they're in our store as well, and so the approach we're talking to that, which is borne out by the consumer focus groups we've been doing, is that we need to play to our strengths, which goes to the assortments and, importantly, the expertise. People come to the Sally store because they know that, A, we've got a broad expert assortment, but, B, they can ask questions and will generally be able to get some good advice without having to pay to go to a stylist. Don't forget that our team members are early adopters and heavy users of our categories, and that shows in virtually every consumer conversation we have in the store. Importantly for us, with the launch of the app and what the app will iterate into over the course of the next couple of quarters, we are finding ways to drive that in-store expertise into the digital channel as well, and so that it's not just about the white screen, here's a set of products and a price, it's also about how do we guide you down the path of what do you want and what do you need and what support do we provide relative to the use of the product, because coloring your hair has some risks, right, people want to have confidence that they're taking this stuff and it's going to look great when they're done, and we think we can provide that both in-store and digitally in ways that others can't.

All right. That makes sense. And then just on SG&A, that continues to come in quite nicely, reflective of the cost-save efforts that you've had. Can you talk through the key buckets that are driving those cost saves and sort of the sustainability around that?

Yes. So a couple thoughts there, and I have to start with a simple proposition, which is there is very little that falls within SG&A that the team at Sally Beauty Holdings has not attacked over the course of the last year and a half, whether it has been the people cost that we have from what are the number of resources we have and where and how, down through our technology costs, where we're investing but also optimizing, and down through the costs as it relates to the movement of goods, if you will. I mean, we have gone after virtually every element. Now, that is not to say there is not incremental opportunity, because the team has gotten very good at finding those nuggets of opportunity. What I would say as well is this year has been a heavy investment year for us, and what's remarkable to me as CFO is the high-level investments we've made at the same time that we're delivering favorability in SG&A. And so what we have found from an SG&A perspective has actually been used to help us invest in the business, and that will continue. We'll go looking for further opportunities. As I think about Q4, and as I think about the future year as well, we have further opportunities in SG&A, but we have even bigger opportunities within cost of goods and the other elements that contribute to gross margin, and so we'll be pursuing those as well. The team here can be very proud of the cost-saving efforts that they've done over the last year, and as we continue to ramp up investment, of course we'll be looking to optimize the enterprise further.

Understood. Thank you so much.

Thank you. And, speakers, with that, I'd like to turn it back over to you for any closing comments.

Thanks to all of you for your questions today. To summarize, we have made tremendous progress so far this year on our transformation efforts in terms of the launch of new, exclusive and innovative brands, the launch of our new loyalty program, and a mobile-first e-commerce platform at Sally. We've made great strides towards updating our point-of-sale and merchandising and supply chain systems, and we've taken significant costs out of the business. In addition, our business is significantly differentiated from our peers due to our defensible core and professional color, high owned and exclusive brand penetration, and a strong community as well as education relationships with stylists in the pro channel. We still have work to do, but remain confident in our strategic position as well as the direction we are headed.

Thank you. Ladies and gentlemen, that does concludes your conference call for today. Thank you for your participation and for using AT&T Executive Teleconference Service. You may now disconnect.