Regis's Cost Cuts Create Shareholder Value

About: Regis Corporation (RGS)
by: Harvard Financial Analysts Club

By Connor Haley

Regis Corporation (NYSE:RGS) owns, operates and franchises low-end hair care salons and hair restoration centers around the world, including well-known brands such as Supercuts, MasterCuts and Magicuts, with a market capitalization of roughly $1 billion. Their core business is resilient in even the most difficult of business climates (hair needs cutting no matter how the economy is doing), which has allowed the company to produce decent results despite poor management. A recent power play by activist investing firm Starboard Value, however, has the potential to unlock the value in this stable, low risk business by cutting excessive costs, making Regis an attractive investment opportunity for value investors.

To begin, the stock is cheap at current valuations even before potential catalysts are considered. It trades at an enterprise value of less than 6 times EBITDA, all while yielding 1.5%, and produces substantial free cash flow yields, averaging over 15% of the current market cap over the past five years. The free cash flows are primarily a result of the cash flow friendly industry model, with low capital requirements and few shifts that require large capital expenditures. A likely reason for these attractive valuation levels is the company's poor management history, with billions of capital expenditures yielding paltry returns for shareholders (ROE for the ttm is negative and ROA is a miniscule 3.68%), a suspicious history of related party transactions and egregious management salaries despite chronic underperformance.

For example, the former CEO, Paul Finkelstein, earned $15 million in compensation from 2008-10 despite a 30% share price decline, and has a beyond-generous retirement plan entitling him to $800,000 per year for life, despite delivering negative same store sales growth during his tenure. In addition, the company maintains multiple regional management teams for its brands despite the similarities between their business models, presenting an easy avenue to lowering costs that has somehow not been taken.

These management faults were an impetus for the involvement of Starboard Value LP, a New York based investment advisor that specializes in unlocking the value in deeply undervalued and poorly managed small cap companies. This past fall, Starboard sought and received three positions on Regis' eight member board, vowing to force cost-cuts and sell of non-core assets (the hair restoration centers, to be precise). Since then, they appear to be successfully changing the company's trajectory.

Randy Pearce, a veteran Regis executive seen my many investors as too much of an insider to enact the needed change, has announced his retirement instead of becoming the CEO as previously planned. Regis also recently cut staff, including 110 workers at its corporate headquarters. These are encouraging signs that Starboard's investment and advice are having positive impacts on Regis' operations, and we expect their influence to remain strong for the foreseeable future.

To measure the potential increase in shareholder value should Starboard be successful, it is useful to consider Regis' operating margins, which have plunged to 2.5% ttm from 7.1% in 2007, largely due to 3.3% increase in SG&A expenses relative to revenue. Returning SG&A to historical levels as Starboard has vowed to do would result in annual cost savings of almost $80 million, raising Regis' expected EBITDA to roughly $250 million. A 6-8X EBITDA multiples, the company would be valued at $32-$43 per share, leaving RGS grossly undervalued at its current share price of $17.62.

We believe the cost cuts proposed by Starboard will be enacted, and that other changes spurred by their activism, including the divestment of non-core businesses, will be beneficial to shareholders. As the company exits its current state of transition, we expect margins to improve to historical levels and the share price to reflect the positive changes wrought by Starboard's shareholder-friendly influence, thus we recommend buying RGS at current prices with a target price of $25/share.

Disclosure: I am long RGS.