One of the challenges of inheriting a 35 stock portfolio that needs to be managed via once weekly meetings is that it's difficult to keep pruned; stocks can linger without a sell motion indefinitely, and making rapid allocation changes is almost impossible. So, even though I might have wanted to sell about half the portfolio and concentrate bets (moving the needle with 35 stocks is difficult), that wasn't going to happen. Now with the market down so much, part of me is loathe to begin shotgun selling the existing holdings in order to rotate into different names – it's a simple function of liking the future performance of XYZ more now that it's down 50%… ugly, I know, but that's the reality for long-only portfolios.
There are still several stocks I really don't like at any price in this kind of economy, though. Salon operator Regis (NYSE:RGS) is one of those, and it was recently sold from the BCIC portfolio. Here's my argument:
When I think narrowly about the traits I want an investment needs to have to stand up to declining consumer spending and bad credit markets, it all comes down to the balance sheet – lots of cash relative to liabilities, a low price-to-tangible-equity, and no near-term maturities if the company does carry debt. Regis meets none of those; it has a current ratio below 1.0 and declining quarter-over-quarter, no tangible equity (all the net book value is tied up in goodwill), and the company has $270 million in long-term debt maturities to meet in the next year. That's more than 20% of non-goodwill assets, or about 10x quarterly operating cash flow.
If Regis can still borrow, it will be costly (it has a speculative-grade credit rating) and will be reinvested in its acquisition-based growth strategy, which shuns same-store comparables growth in favor of increasing store locations. To that end, Regis has spent the last several years leveraging up through buyouts of franchisees (franchised locations down 45% in the last five years) and opening new locations (salons owned up 38% in the last five years). Of note, substantially all of that store growth was concentrated in lower-end salon concepts with an average ticket of less than $20. Those concepts now comprise 75% of the store base and generate 57% of total revenues, and were responsible for more than 90% of revenue growth in the last three years.
Going into what has the markings of a very bad recession, there are many positions I'd rather be in than that of an economically sensitive business that's shown the appearance of growth the last few years by leveraging up to target lower- and middle-class consumers.
Where do I see trouble for this company, beyond the balance sheet? A short while back I came across a spending elasticity graph of various services; hair care was estimated to be 1.3x more variable than general spending. Regis earns great margins (close to 50%) selling hair care products at their locations, and a closer look shows that after expensing items like rent and operating expenses against the main business of hair care service, that actually results in a loss made up by – you guessed it – earning 49% margins on hair product sales. Put another way, Regis' strategy is to get customers in the door at a slight loss, and hope to up-sell them on expensive hair care products. That might have been fine in better economic times, but comps in this segment declined 4.5% in the prior quarter, and they continued to lag salon location growth in the just-released quarter.
In a credit-constrained environment, Regis' balance sheet is already questionable enough to make me not want to own the stock. The strategy of levering up to expand into down-market operations and profiting from high markups on hair care products is truly worrisome; I don't think the stock is a zero – not enough debt, and cash flow is decent – but the company is facing declining visitation comps, a much greater contraction in spending on its profit center, and a debt burden that needs to be met or refinanced in the worst market for credit in generations.
This is to say nothing about the long-run fundamentals of Regis's business; even with their leveraged position (especially relative to tangible capital), their recent return on equity has peaked below 10%. Overall, I don't see this as being an attractive enough business on the other side of the economic cycle to warrant holding.
There is an oft-repeated argument that with such fragmentation in the hair care industry, Regis has a great growth opportunity to consolidate market share. It's true that it can grow store base and thus revenues more or less indefinitely as long as it can gain access to debt funding, but as stated above, on an economic basis there is not much value being created here.
(Here are the slides used in my sell presentation; the relevant part begins at Slide 11.)
Stock position: None.