Derivative Instruments and Hedging Activities

12 Months Ended

Sep. 30, 2014

Derivative Instruments and Hedging Activities

Derivative Instruments and Hedging Activities

14. Derivative Instruments and Hedging Activities

Risk Management Objectives of Using Derivative Instruments

The Company is exposed to a wide variety of risks, including risks arising from changing economic conditions. The Company manages its exposure to certain economic risks (including liquidity, credit risk, and changes in foreign currency exchange rates and in interest rates) primarily: (a) by closely managing its cash flows from operating and investing activities and the amounts and sources of its debt obligations; (b) by assessing periodically the creditworthiness of its business partners; and (c) through the use of derivative instruments from time to time (including, foreign exchange contracts and interest rate swaps) by Sally Holdings.

The Company from time to time uses foreign exchange contracts (including foreign currency forwards and options), as part of its overall economic risk management strategy, to fix the amount of certain foreign assets and obligations relative to its functional and reporting currency (the U.S. dollar) or relative to the functional currency of certain of its consolidated subsidiaries, or to add stability to cash flows resulting from its net investments (including intercompany notes not permanently invested) and earnings denominated in foreign currencies. The Company's foreign currency exposures at times offset each other, sometimes providing a natural hedge against its foreign currency risk. In connection with the remaining foreign currency risk, the Company uses foreign exchange contracts to effectively fix the foreign currency exchange rate applicable to specific anticipated foreign currency-denominated cash flows thus limiting the potential fluctuations in such cash flows as a result of foreign currency market movements.

The Company from time to time has used interest rate swaps, as part of its overall economic risk management strategy, to add stability to the interest payments due in connection with its debt obligations. At September 30, 2014, our exposure to interest rate fluctuations relates to interest payments under the ABL facility, if any, and the Company held no derivatives instruments in connection therewith.

As of September 30, 2014, the Company did not purchase or hold any derivative instruments for trading or speculative purposes.

Designated Cash Flow Hedges

In 2008, Sally Holdings entered into certain interest rate swap agreements with an aggregate notional amount of $300 million which enabled it to convert a portion of its then variable interest rate obligation, to a fixed-interest rate obligation. These agreements were designated and qualified as effective cash flow hedges. Accordingly, changes in the fair value of these derivative instruments (which were adjusted quarterly) were recorded, net of income tax, in accumulated other comprehensive (loss) income ("AOCI") until the swap agreements expired in May 2012. Amounts previously reported in AOCI which were related to such interest rate swaps were reclassified into interest expense, as a yield adjustment, in the same period in which interest on the hedged variable-rate debt obligations affected earnings. As such, for the fiscal year ended September 30, 2012, the Company's other comprehensive income included deferred gains on these interest swaps of $3.9 million, net of income tax.

Non-designated Cash Flow Hedges

The Company may use from time to time derivative instruments (such as foreign exchange contracts and interest rate swaps) not designated as hedges or that do not meet the requirements for hedge accounting, to manage its exposure to interest rate or foreign currency exchange rate movements, as appropriate.

The Company uses foreign exchange contracts to manage the exposure to the U.S. dollar resulting from certain of its international subsidiaries' purchases of merchandise from third-party suppliers. These subsidiaries have a functional currency other than the U.S. dollar—their functional currency is either the British pound sterling or the Euro. As such, at September 30, 2014, we hold: (a) foreign currency forwards which enable us to sell approximately £6.5 million ($10.6 million, at the September 30, 2014 exchange rate) at the weighted average contractual exchange rate of 1.6277 and (b) foreign currency forwards which enable us to sell approximately €10.8 million ($13.7 million, at the September 30, 2014 exchange rate) at the weighted average contractual exchange rate of 1.2903. These foreign currency forwards expire ratably through September 21, 2015.

The Company also uses foreign exchange contracts to mitigate its exposure to changes in foreign currency exchange rates in connection with certain intercompany balances not permanently invested. As such, at September 30, 2014, we hold: (a) a foreign currency forward which enables us to sell approximately €17.0 million ($21.4 million, at the September 30, 2014 exchange rate) at the contractual exchange rate of 1.2690, (b) a foreign currency forward which enables us to sell approximately $2.1 million Canadian dollars ($1.9 million, at the September 30, 2014 exchange rate) at the contractual exchange rate of 1.1210, (c) a foreign currency forward which enables us to buy approximately $12.7 million Canadian dollars ($11.4 million, at the September 30, 2014 exchange rate) at the contractual exchange rate of 1.1183, (d) a foreign currency forward which enables us to sell approximately 32.6 million Mexican pesos ($2.4 million, at the September 30, 2014 exchange rate) at the contractual exchange rate of 13.4525 and (e) a foreign currency forward which enables us to buy approximately £1.2 million ($2.0 million, at the September 30, 2014 exchange rate) at the contractual exchange rate of 1.6234. All the foreign currency forwards discussed in this paragraph expire on or before December 31, 2014.

In addition, the Company uses foreign exchange contracts including, at September 30, 2014, foreign currency forwards with an aggregate notional amount of £3.0 million ($4.9 million, at the September 30, 2014 exchange rate) to mitigate the exposure to the British pound sterling resulting from the sale of products and services among certain European subsidiaries of the Company. The foreign currency forwards discussed in this paragraph enable the Company to buy British pound sterling in exchange for Euro currency at the weighted average contractual exchange rate of 0.7976 and expire ratably through September 30, 2015.

At September 30, 2014, all of the Company's foreign exchange contracts are with a single counterparty. The Company's foreign exchange contracts are not designated as hedges and do not currently meet the requirements for hedge accounting. Accordingly, the changes in the fair value (i.e., marked-to-market adjustments) of these derivative instruments, which are adjusted quarterly, are recorded in selling, general and administrative expenses in our consolidated statements of earnings. Selling, general and administrative expenses include net gains of $1.9 million and $2.0 million in the fiscal years ended September 30, 2014 and 2012, respectively, and net losses of $2.8 million in the fiscal year ended September 30, 2013 in connection with all of the Company's foreign currency derivative instruments, including marked-to-market adjustments.

The table below presents the fair value of the Company's derivative financial instruments as well as their classification on the Company's consolidated balance sheets as of September 30, 2014 and 2013 (in thousands):

	Asset Derivatives					Liability Derivatives
		As of September 30,					As of September 30,
	Classification	2014		2013		Classification	2014		2013
Derivatives designated as hedging instruments:
None			—		—			—		—
			—		—			—		—
Derivatives not designated as hedging instruments:
Foreign Exchange Contracts	Other current assets	$	511	$	152	Accrued liabilities	$	47	$	36
		$	511	$	152		$	47	$	36

The table below presents the effect of the Company's derivative financial instruments on the Company's consolidated statements of earnings for the fiscal years ended September 30, 2014, 2013 and 2012 (in thousands):

	Amount of Gain or (Loss) Recognized in OCI on Derivative (Effective Portion), net of tax						Amount of Gain or (Loss) Reclassified from Accumulated OCI into Income (Effective Portion)
	Fiscal Year Ended September 30,							Fiscal Year Ended September 30,
Derivatives Designated as Hedging Instruments	2014		2013		2012		Classification	2014		2013		2012
Interest Rate Swaps	$	—	$	—	$	3,947	Interest expense	$	—	$	—	$	(6,731	)

		Amount of Gain or (Loss) Recognized in Income on Derivatives
		Fiscal Year Ended September 30,
	Classification of Gain or (Loss) Recognized into Income
Derivatives Not Designated as Hedging Instruments		2014		2013			2012
Foreign Exchange Contracts	Selling, general and administrative expenses	$	1,935	$	(2,846	)	$	2,003
Total derivatives not designated as hedging instruments		$	1,935	$	(2,846	)	$	2,003

There were no gains or losses recognized in income on derivatives designated as hedging instruments as a result of ineffectiveness or the exclusion of such derivatives from effectiveness testing during the fiscal years ended September 30, 2014, 2013 and 2012.

Credit-risk-related Contingent Features

At September 30, 2014, the aggregate fair value of all foreign exchange contracts held which consisted of derivative instruments in a liability position was less than $0.1 million. The Company was under no obligation to post and had not posted any collateral related to the agreements in a liability position.

The counterparties to all our derivative instruments are deemed by the Company to be of substantial resources and strong creditworthiness. However, these transactions result in exposure to credit risk in the event of default by a counterparty. The financial crisis that has affected the banking systems and financial markets in recent years resulted in many well-known financial institutions becoming less creditworthy or having diminished liquidity which could expose us to an increased level of counterparty credit risk. In the event that a counterparty defaults in its obligation under our derivative instruments, we could incur substantial financial losses. However, at the present time, no such losses are deemed probable.