Though it has been a long time since I’ve been in a hair salon, I do find the industry to be attractive for a number of reasons. First, most people view a haircut as non-discretionary so sales tend to hold up quite well throughout recessions. Second, though explicit switching costs are low, most people form a relationship with their stylist that acts as an implicit switching cost. Third, the hair salon industry is not capital intensive and undergoes only very slow change, allowing for consistent and strong free cash flows. Fourth, though the industry is populated with small independents (RGS, the market leader, accounts for less than 2% of the industry’s sales), this is an industry where size counts for a great deal. For example, large commercial landlords (those that own the best retail locations) are much more likely to do a deal with a large chain like RGS than with an independent. Furthermore, economies of scale in terms of product purchasing, advertising, and design and construction costs are enormous as compared to one-off independents.
In my initial glance at RGS, I was impressed by its free cash flow. Let’s take a look together:
Regis Corporation - Free Cash Flow, 1995 - 2011
Over the last eight years, the company has generated an average free cash flow margin of 6%, enjoying an average of $140 million in free cash flow annually. This translates to a yield at the current market cap of 15%. Moreover, a little over $15 million of the company’s capital expenditures (the difference between CFO and FCF in the chart above) would be classified as growth expenditures, which are discretionary, and thus truly “free” cash flows that could be returned to shareholders. Adding these back to FCF would result in a yield of 17%.
Buying a company with a commanding position in a stable industry with consistent and free cash flows, at a low multiple should spell investment success, right? Not so fast. It is incumbent upon the investor to determine whether there are any red flags to suggest that free cash flows won’t be so consistent in the future.
Let’s dig in. First, aggregate revenues and margins.
Regis Corporation - Revenues and Margins, 1995 - 2011
Here we see that the company’s gross margins have been largely flat throughout the entire period, while the company’s operating margin has contracted quite a bit, with a downward trend since 2004. Revenues have declined 6.3% since 2008′s peak, but this is on the aggregate level and the company has reduced its store count (selling off Trade Secrets a few years ago and closing some locations in its other banners). Looking at the company’s change in same store sales, we see a cumulative decline over the last three years of 7.21%.
The most concerning thing here in terms of potentially affecting free cash flows is the company’s operating margin contraction. Unfortunately, this is not the result of a massive increase in depreciation and amortization (which was essentially steady between 2011 and 2007). Adjusting both 2007 and 2011 to eliminate Goodwill impairments, we find the company’s operating margin to have contracted by a staggering 358bp. Of this, 80bp is due to a contraction in gross margins, 110bp is due to an increase in site operating expenses, 160bp is due to an increase in general and administrative expenses. Simply put, the costs of managing the business have increased. In fact, the company’s G&A expense as a percent of revenues is by far the highest it has ever been, at 14.7% of revenues (relative to a 17 year average of just 11.9%).
I am not the only one concerned about the increasing cost of managing this business. An activist hedge fund, Starboard Value LP (a spin-off of hedge fund Ramius which was agitating for change at Zoran, discussed here), has set its sights on RGS due in large part to the company’s declining EBITDA margin and sub-par stock performance. On September 15th, Starboard filed an initial SC-13D announcing ownership of 5.1% of RGS including an exhibit with Starboard’s letter to the company’s Chairman and CEO. That letter stated, in part:
[W]e believe that Regis is deeply undervalued and that opportunities exist to greatly improve both operating and stock price performance based on actions within the control of management and the Board of Directors (the “Board”). …Starboard suggested that there should be around $100 million of expenses that could be eliminated and that non-core assets should be spun off. Starboard requested three seats on the Board. Quite expectedly, RGS rejected Starboard’s requests, setting off a proxy war between the parties, with all eyes pointed toward the annual meeting later in October. Also expectedly, RGS has unveiled “new strategic initiatives” to enhance shareholder value, complete with a slide deck. The gist of it is that they are committing to looking at alternatives for their Hair Club, Provalliance and Empire Education Group assets, they expect to achieve $40-50 million of cost savings (though the methods for achieving this are, at best, vague. It is also worth noting that their previous strategic initiatives set for $20 – $30 million in savings. Interesting how the presence of an activist hedge fund suddenly illuminates another $10 – $30 million in waste), and that over the next year they will separate the CEO and Chairman role, with the current CEO and Chairman set to retire.
Based on our research, we have concluded that the Company’s core North American salon business is a strong and valuable business due to its ability to generate significant free cash flow and a high return on equity. Furthermore, the salon business is relatively recession-resistant, has little risk of technological change, and enjoys a greater degree of stability than most specialty retailers because it provides services that are generally considered to be non-discretionary. Despite these favorable business characteristics, we believe Regis trades at a steep discount to the sum of its parts and only 4.6x the consensus estimate for 2012 EBITDA(1), far below its specialty retail peers. …
Despite having gross margins that are among the highest of its specialty retail peer group, Regis’ operating margins are among the lowest in the group. The Company’s inability to adjust its cost structure to a lower revenue base has resulted in four years of declines in operating income. Over the past 12 months, general and administrative expenses amounted to $310 million. This represents 13.4% of revenue, and appears to indicate that Regis has a higher portion of its cost structure dedicated to corporate overhead than virtually any other U.S. retailer of a similar size.
RGS says that it has already achieved $43 million in cost savings since 2009. This is disingenuous, as the company’s EBITDA margin has shrunk, as noted above. In a response from Starboard, the hedge fund accurately points out that any savings in one line item have been offset by growth in other line items. I also take issue with RGS’ statement on slide 32 “Starboard platform is not compelling… No revenue initiatives – not a growth plan.” If this company believes that the only compelling strategy is one that focuses on revenue, this is a clear problem.
Starboard responded with an updated proxy solicitation that uncovers this juicy piece of information (emphasis added):
Additionally, we note that Paul Finkelstein, the Company’s CEO, collected nearly $15 million in compensation from 2008 through 2010, despite a Share price decline of over 30% during that same time frame. The Company has also agreed to pay Mr. Finkelstein, commencing upon his retirement, an amount equal to 60% of his salary, adjusted for inflation, for the remainder of his life.This is quite a parting gift for Finkelstein and his wife, amounting to (according to Starboard) $800,000 per year for the rest of Finklestein’s life and $400,000 for his wife after he dies and until she dies. I think it says a lot about corporate governance at RGS.
We note further that the Company has a survivor benefit plan payable upon Mr. Finkelstein’s death at a rate of one half of his deferred compensation benefit, adjusted for inflation, for the remaining life of his spouse, and other unfunded deferred compensation contracts covering key executives within the Company. The Company estimates the accrued liability and projected benefit obligation of these deferred compensation contracts totals over $33 million.
Starboard raises a number of other corporate governance concerns, including some questionable related party transactions and a ridiculous put/call arrangement on the Provalliance deal. Starboard isn’t the only party questioning RGS’ corporate governance; Glass Lewis & Co and ISS Proxy Advisory Services both recommend shareholders withhold votes for various members of the Board.
Starboard also released a slide deck of its own, providing the details to its multifaceted argument that change is needed at RGS.
So where does all of this leave us ?As noted at the beginning of this article, the company has produced significant free cash flows over the last five years. According to Starboard, there is a lot of room to expand this free cash flow. Assuming the $80 – $100 million in expense savings that Starboard identifies is a realistic figure, this works out to say $50 – $60 million after taxes as free cash flow. Split the difference and add $55 million in free cash flow to the $155 million discussed above (which includes a only maintenance capex), we get a potential free cash flow yield of 23%.
In valuing RGS, I looked at two categories of scenarios. In one category, Starboard loses the proxy war. In this situation, management will be far less aggressive in cutting costs, but given the fire underneath them courtesy of Starboard, we should see margin improvement from this past year. In the other category, Starboard wins the proxy war, and margin improvement is more aggressive. In both categories, I expect any improvements to occur not until fiscal 2013. For each category, I looked at a variety of potential cost savings and timelines for these savings to be achieved.
Here’s the key: in both categories of situations the company is cheap. Really cheap. Though, for my money, I’d like to see Starboard victorious. Here’s hoping!
What do you think of Regis Corporation?
Author Disclosure: No position, but may initiate within 72 hours.