Elie Rosenberg is a value investor based out of Dallas, Texas. He is the founder and editor of Value Slant
Regis Corp. (RGS) is the largest hair salon company in the world, with 12,700 worldwide locations. The recession has hit Regis same store sales (SSS) growth and the stock now trades at 5X EBITDA and a 16% levered free cash flow yield. The rate of decline in SSS has slowed and management is guiding for flat SSS next year. Regis might be compelling due to their cheap valuation, strong position in a stable industry, and the possibility of monetizing some attractive non-core assets. These attributes have attracted the attention of the activist fund Starboard Value (formerly part of Ramius), which recently delivered a letter seeking change and board representation at RGS. What does a closer look reveal about RGS?
|Price as of 8/29/2011||14.70|
|52 Week Range||12.84-21.69|
|Shares Out (MMs)||57.7|
|Market Cap (MMs)||848.2|
|Net Debt (MMs)||217.1|
|Enterprise Value (MMs)||1,065.3|
RGS has grown massively over the last decade by rolling up small salon operations both in North America and Europe, nearly doubling their salon count from 6,681 in 2001 to the current 12,700. The industry seems to be amicable to a roll-up strategy due to the steady recurring revenue and no threat of obsolescence. RGS is the only large consolidator in the industry, and the industry is still extremely fragmented as RGS only has a 4% market share in North America and 2% worldwide. That leaves plenty of growth opportunities. As the exit options for small salon operators are limited, RGS can typically acquire their operations at only 3.5-5X historical cash flow.
While haircuts are fairly recession resistant, RGS has posted three straight years of same-store sales declines (-3.1%,-3.2%, and -1.7% from 09-11). This has mainly been due to a hit to their higher end Regis line. Their higher end salons ($40 average ticket) make up 15% of sales, while 85% of sales are “value” salons like the Supercuts chain ($16-20 average ticket). Additionally, there is also the impact of people stretching out the time between haircuts in an economic downturn. The company sees SSS bottoming out and has guided for -1% to 1% SSS growth in fiscal year 2012 (their fiscal year ends in June).
The main problem with Regis is that they do not appear to be adding value through their salon growth, and the company has not responded by radically altering their cost structure or halting spending on new salons. One of the main objectives in a roll-up strategy is to use the corporate platform to achieve economies of scale and expand margins as revenues grow. Regis has done the opposite, with operating margins shrinking as revenues have grown.
Starboard noted this in their letter, although they made the argument in an odd way. They noted that RGS has some of the highest gross margins among their peer group of specialty retailers (as defined in their proxy), while almost the lowest operating margins. While I agree with their larger point that RGS has a bloated cost structure, I don’t think comparing RGS margins to the likes of AutoZone or Foot Locker is very helpful because none of their “peers” actually operate within their industry. It might be more informative to look at RGS margins on a historical basis. Let’s compare Regis’ results from FY 2002 to FY 2011:
(results have been normalized by taking out asset impairment charges and a valuation allowance on a note receivable running through G&A)
Looking at the bottom line, EBIT margins have declined 450 basis points despite revenues growing 60%. Gross margin has actually increased from 45% to 45.7% so that is not the culprit. Site operating expense (miscellaneous operating expense on the salon level outside of labor and materials) has also remained steady. 1.5% of the drop is due to increased rent and D&A, which we probably can blame on the negative leverage of declining same store sales in the last few years. But by far the largest drain has been G&A, which has gone from 9.6% of sales to 13.3%. Regis’ consolidation platform has become less efficient as they have grown, making their continuous growth capex spend value destructive.
Management has focused on enhancing marketing to improve same store comps as their top priority, and have not made cost cutting a major focus. That is despite the fact that hair salons are traditionally not marketing driven companies, and the decline in SSS probably has more to do with the economy than losing market share.
Regis has guided for only $20-30 million in cost cuts next year, while it would take $105 million in cuts to bring operating margins in line with 2002 levels. Starboard is pushing for $100 million in cuts, but they are fighting an uphill battle. Randy Pearce came in as the new top executive in February, but he is a long time Regis exec who has not layed out a radical change in approach. On top of their lack of commitment to cost containment, management is planning on $140 million in growth capex in the next two years.
RGS is a great activist target because there is clearly value to be unlocked, and Starboard has the right strategy of forcing management to rightsize the cost structure and divest some non-core assets (European salons, Hair Club, and the beauty school). But I am not sure how far they will get with only 4.4% of the stock. So we are left with a cheap stock and a decent business at its core, but one that has near term top line weakness (SSS were down 3.7% through 7 weeks of Q1), bloated operating expenses, and poor capital allocation. If Starboard can get board representation then that might make the situation more interesting, but for now I don’t see RGS changing its tune.
Disclosure: No position