Derivative Instruments and Hedging Activities

9 Months Ended

Jun. 30, 2013

Derivative Instruments and Hedging Activities

Derivative Instruments and Hedging Activities

11. 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, 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 June 30, 2013, 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 June 30, 2013, 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 obligations under the term loan B facility, to fixed-interest rate obligations. These agreements were designated and qualified as effective cash flow hedges, in accordance with ASC Topic 815, Derivatives and Hedging (“ASC 815”). 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 three and nine months ended June 30, 2012, the Company’s other comprehensive income included deferred gains on these interest swaps of $1.0 million and $3.9 million, respectively, net of income tax of $0.7 million and $2.5 million, respectively.

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 including, at June 30, 2013, foreign currency forwards with an aggregate notional amount of $3.0 million to manage the exposure to the U.S. dollar resulting from certain of our Sinelco Group subsidiaries’ purchases of merchandise from third-party suppliers. Sinelco’s functional currency is the Euro. These foreign currency forwards enable Sinelco to buy U.S. dollars at a contractual exchange rate of 1.2772, are with a single counterparty and expire ratably through September 2013.

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 June 30, 2013, we held: (a) a foreign currency forward which enables us to sell approximately €26.0 million ($33.8 million, at the June 30, 2013 exchange rate) at the contractual exchange rate of approximately 1.3019, (b) a foreign currency forward which enables us to sell approximately $2.3 million Canadian dollars ($2.2 million, at the June 30, 2013 exchange rate) at the contractual exchange rate of 1.0519, (c) a foreign currency forward which enables us to buy approximately $26.2 million Canadian dollars ($24.9 million, at the June 30, 2013 exchange rate) at the contractual exchange rate of 1.0488, (d) a foreign currency forward which enables us to sell approximately 18.7 million Mexican pesos ($1.4 million, at the June 30, 2013 exchange rate) at the contractual exchange rate of 13.0095 and (e) a foreign currency forward which enables us to sell approximately £9.0 million ($13.7 million, at the June 30, 2013 exchange rate) at the contractual exchange rate of approximately 1.5310. The foreign currency forwards discussed in this paragraph are with a single counterparty, not the same party as the counterparties on the other forwards held at June 30, 2013, and expire on or before September 30, 2013.

In addition, the Company uses foreign exchange contracts including, at June 30, 2013, foreign currency forwards with an aggregate notional amount of €0.9 million ($1.2 million, at the June 30, 2013 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 0.8154, are with a single counterparty, not the same party as the counterparties on the other forwards held at June 30, 2013, and expire ratably through September 2013.

The Company’s foreign currency derivatives are not designated as hedges and do not currently meet the hedge accounting requirements of ASC 815. Accordingly, the changes in fair value of these derivative instruments, which are adjusted quarterly, are recorded in our consolidated statements of earnings. Selling, general and administrative expenses reflect net losses of $1.2 million and net gains of $2.2 million for the three months ended June 30, 2013 and 2012, respectively; and net losses of $0.9 million and net gains of $2.6 million for the nine months ended June 30, 2013 and 2012, respectively, including marked-to-market adjustments, in connection with all of the Company’s foreign currency derivatives.

The table below presents the fair value of the Company’s derivative financial instruments as well as their classification on the balance sheet as of June 30, 2013 and September 30, 2012 (in thousands):

	Asset Derivatives					Liability Derivatives
	Classification	June 30, 2013		September 30, 2012		Classification	June 30, 2013		September 30, 2012
Derivatives designated as hedging instruments:
None
Derivatives not designated as hedging instruments:
Foreign Exchange Contracts	Prepaid expenses	$	98	$	4	Accrued liabilities	$	248	$	132
		$	98	$	4		$	248	$	132

The table below presents the effect of the Company’s derivative financial instruments on the statements of earnings for the three months ended June 30, 2013 and 2012 (in thousands):

Derivatives	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)
Designated as	Three Months Ended June 30,					Three Months Ended June 30,
Hedging Instruments	2013		2012		Classification	2013		2012
Interest Rate Swaps	$	—	$	1,027	Interest expense	$	—	$	(1,670	)

		Amount of Gain or (Loss) Recognized in Income on
	Classification of Gain or	Derivatives
Derivatives Not Designated as	(Loss) Recognized into	Three Months Ended June 30,
Hedging Instruments	Income	2013			2012
Foreign Exchange Contracts	Selling, general and administrative expenses	$	(1,163	)	$	2,239

The table below presents the effect of the Company’s derivative financial instruments on the statements of earnings for the nine months ended June 30, 2013 and 2012 (in thousands):

Derivatives	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)
Designated as	Nine Months Ended June 30,					Nine Months Ended June 30,
Hedging Instruments	2013		2012		Classification	2013		2012
Interest Rate Swaps	$	—	$	3,947	Interest expense	$	—	$	(6,731	)

		Amount of Gain or (Loss) Recognized in Income on
	Classification of Gain or	Derivatives
Derivatives Not Designated as	(Loss) Recognized into	Nine Months Ended June 30,
Hedging Instruments	Income	2013			2012
Foreign Exchange Contracts	Selling, general and administrative expenses	$	(878	)	$	2,611

Credit-risk-related Contingent Features

At June 30, 2013, the aggregate fair value of all foreign exchange contracts held which consisted of derivative instruments in a liability position was $0.2 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.