As we brace for our nation’s one-way ticket to the poorhouse, it behooves savvy investors to position their portfolios accordingly. Finding stocks that will hold up, and potentially even flourish, during periods of macroeconomic weakness is no small task. However, it is precisely these companies that will insulate an investor’s portfolio during the lean years. One company that is well positioned at the intersection of the prevailing (and approaching) macroeconomic headwinds is Regis Corp (RGS).
Regis Corp (RGS) owns, franchises, or holds ownership interests in beauty salons, hair restoration centers, and cosmetology educational institutions worldwide. RGS is the global leader in the beauty salon industry with a market share that is 10x the size of the next largest competitor. RGS targets the mass market value oriented customer and places salons in convenient locations with high customer traffic, such as shopping centers, regional malls, and inside Walmart (WMT).
As of March 31, 2011 RGS owns 7,991 locations, has 1,937 franchises, and has a 47% ownership stake in a JV called Provallilance which has 2,763 locations and is the largest salon operator in Europe. RGS also owns 96 hair restoration centers and owns a 55% stake in a JV called Empire Education, which is the largest beauty school operator in North America with 102 accredited cosmetology schools. RGS salons operate under the names Supercuts, Sassoon Salon, Regis Salons, MasterCuts, SmartStyle, Cost Cutter, Cool 4 Kids, and Hair club for Men and Women. The European locations operate under the names Jean Louis David, Franck Provost, and Saint Algue.
RGS is currently trading near its 52 week low as a confluence of events have led to a significant decline in the stock price. The stock had a considerable run last fall as the company announced it was putting itself up for sale; however, the stock subsequently crashed back down after the bids received were deemed insufficient.
Several unusual events over the past several quarters have temporary impaired the financial results of RGS which has masked the stability and profitability of the business model. The trading noise and extraneous expenses are distracting investors from the attractive underlying FCF generation. The staple nature and recurring demand for RGS makes the business relatively insulated from macroeconomic woes. Should we see a double dip recession, the consumer trade-down to RGS salons should cushion much of the blow resulting from existing customers waiting longer between haircuts.
The market is currently attributing zero value to RGS two substantial joint ventures. I see these investments being worth an incremental $3 per share. The stock pays a 1.8% dividend yield which will generate some return while investors wait for sentiment to turn. I see the stock as currently mispriced and estimate fair value for the equity to be $20 per share.
Boom/bust following failed auction and messy financials result in a mispriced stock
RGS had an eventful fall last year as the stock rallied +42% after RGS announced that it was exploring strategic alternatives for the company, which ultimately meant an auction. However, the stock apparently got ahead of itself and it was reported that the private equity buyers submitted bids that were ~$19 per share, which was below the market price (+$21) at the time. The stock plummeted following this news and again in mid December when the company formally pulled the plug on the strategic review. The stock is down -32% from the height of the take-over speculation.
click to enlarge images
Compounding the matter was RGS being hit with several transitory events that have weighed on profitability over the past few quarters. In early 2009, RGS sold the Trade Secret salon concept, which consisted of 712 mall-based salons, to a company called Premier Salons.
As part of the deal, RGS provided the purchaser with a $33m note to help finance the deal. Unfortunately the purchaser filed for Chapter 11 bankruptcy last summer and has not been making the schedule interest payments to RGS. As a result, RGS has been taking valuation allowances which have been weighing on profitability. Last quarter, RGS took a $9m ($.13 per share) valuation reserve against this note. Currently there is still $22.4m of the note receivable on the RGS balance sheet.
Whether or not RGS gets made whole on this note will not make or break this investment, but it has been “death by a hundred paper cuts” as every quarter this hits the bottom line for a few million dollars. Also hurting profitability was the earthquake in Japan, which negatively impacted its investment in the Japanese salon company MY Style.
Last quarter, RGS took an $8.7m charge due to a decline in the projected revenue growth rates and corresponding equity value following the earthquake. RGS does not do a good job of breaking out the impact of these one-time items, resulting in very messy financial statements. I suspect that a lot of investors just avoid this situation because it is messy, time consuming, and the company is not all that exciting to begin with.
Revenue decline due to locations closings and divestiture, underlying fundaments stable
Bears will point to the stagnant top line as a sign that the business is struggling when in reality this has been driven by store closings, divestitures (Trade Secret), and JV investments (Empire Education and Provalliance) transitioning to equity method accounting. RGS closed 229 locations in 2009, 249 locations in 2010, and sold 712 locations in the Trade Secret transaction.
The underlying business was remarkably stable throughout the Great Recession as revenue per store and profit margins remained relatively firm, demonstrating the defensive characteristics of this business model. When tough economic times hit, there are two things that typically happen within the hair salon space. The first thing is that people make their haircuts last longer by extending the time between cuts, which is negative for overall industry volumes. However, the second phenomenon is that consumers also trade down to cheaper haircut options, which is a positive for the RGS business model (average haircut is $15). During the past recession these two forces seemed to counteract each other and leave RGS relatively insulated from the economic carnage, which removes the cyclical risk from this stock. RGS is also insulated from the threat of technological obsolescence and foreign competition.
Market is attributing zero value to JV investments, free call option on $220m businesses
RGS has two large joint venture investments (Provalliance and Empire Education) that I see as particularly valuable, yet I do not believe the market is attributing much (if any) value to either. Both of these entities originated out of mergers. In January 2008, RGS merged its continental European franchise operations with Franck Provost Salon Group to create Provalliance, which is the large salon operator in Europe with approximately 2,500 salons as of March 31 2011.
Empire Education, which is the largest cosmetology school operator in North America with 102 accredited schools, is the other JV and was created by a merger in April 2007. The reason I say that the value of these two business is not reflected in the stock price is because these business are accounted for using the equity method that puts their impact at the bottom of the income statement, which is often excluded from traditional valuation techniques such as a DCF calculation and metrics like EV/EBITDA or price/sales. RGS is trading at 5.7x EBITDA and 97% of book value, which suggests that not only is the underlying business undervalued, but these two JVs are also getting completely ignored.
RGS recently increased its ownership stake in Provalliance by 17% for a payment of $56m, which equates to an enterprise value of $330m for Provalliance. A $330m valuation would equate to a 7.3x EBITDA multiple, which is inline with the historical average for RGS. RGS owns 47% of the entity so this investment is worth $155m or over $2 per share. Empire Education generates roughly $200m in annual revenue, $20m in operating income, and $12m in net income. If we apply a 10x multiple to annual net income this business is worth $120m (would equate to 4.3x EBITDA). RGS owns 55% of this JV so its share is worth ~$66m or $.95 per share. From talking with the company it sounds like RGS tried to monetize the Empire Education business two years ago and received offers at 10x EBITDA, however the uncertainty surrounding the gainful employment regulations caused interest to disappear. With gainful employment now behind us, I think it’s reasonable to believe that a bidder could resurface. I estimate that these JVs are worth ~$3 per share in total.
Negative Wall Street analyst sentiment, high short interest, stable dividend
RGS is covered by the sell-side, although I would argue that none of them are experts on the hair salon space since RGS is the only publicly traded company in the industry. Most of these analysts cover apparel retail, which is not an apples-to-apples proxy for hair salons. Of the 10 analysts, only 3 have buy ratings versus 6 holds and 1 sell. RGS has a fairly high short interest with 16% of the float short; it would take 16 trading days for the shorts to cover their position. This bearish sentiment suggests that expectations are low, which should limit our downside as well as provide possible upward catalysts as sentiment improves. The stock pays a 1.8% dividend yield, which will generate some return while we wait for sentiment to turn. The dividend was paid continuously throughout the financial crisis.
- The economy slips back into a recession, leading to higher unemployment and lower consumer spending. This would likely result in consumers waiting longer between haircutsת however the trade-down of consumers from higher priced salons should help cushion this blow. A severe depression type environment could result in people cutting their own hair/not caring about their hair.
- Walmart (WMT) decides to get out of the salon business and does not renew leases with RGS. This would be very damaging as 26% of RGS locations are with Walmart. This risk seems very unlikely as WMT benefits by leasing this space at a higher rate than would be earned otherwise by selling merchandise. WMT and RGS have had a good working relationship for many years.
- Mall-based shopping becomes obsolete. RGS still has ~15% of its locations (Regis Salons & Mastercuts) located in malls, however the company has been getting away from these locations and concepts for the past several years. Over the past three years, RGS has closed a net total of 70 salons based in malls.
- Fashion risk - if longer hair were to become very fashionable, it would result in lower customer visits.
One does not need to believe that the US is headed for another recession in order for this stock to work. At the current valuation, I see the equity producing alpha in both a growing economy and, more importantly, a recessionary environment.
As investors, we need to understand the value of time and the opportunity cost of capital. Therefore, we should strive to avoid sitting on dead money for an extended period of time. The perfect investment will combine underappreciated positive fundamentals, a compelling valuation, and a catalyst. A catalyst for RGS was provided on August 16th in the form of an announcement from an activist investor that has taken a stake in the company. This type of activist activity increases the probability that RGS will unlock the hidden value discussed above.
Disclosure: I am long RGS.