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Driving a Higher ROE With Regis

Investment thesis based on Buffett's favorite metric

March 20, 2017 | About:

This post's goal is to uncover companies improving productivity, profitability and capital structure. Improving these component drivers will ultimately lead to a higher ROE (a higher stock price). Warren Buffett (Trades, Portfolio) has commented that the returns a company gets on equity is the key factor for a profitable investment. Simply, ROE reports how well a company is doing. My discovery process helped uncover several potentially compelling companies. For today, I will focus on Regis Corp.

Regis Corp (NYSE:RGS) is the beauty industry's global leader in hair salons and cosmetology education. It owns, franchises and operates beauty salons that offer haircutting and hair coloring, and markets a wide selection of professional haircare products to its customers.

Brand names

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Above, I mentioned that this post started with a search for companies improving productivity, profitability and capital structure. Essentially, companies driving a future higher ROE before the stock price reflects improved results (more on this below).

Why is Regis an attractive investment?

Let's start with the current historical and industry cheap valuation: EV/EBITDA = 6.03, P/S = .30 versus related industry = 1.70, P/B = 1.10 versus related industry = 9.50, 52-week stock price change = -19.02%, cash per share = $3.36. More current valuation measures are in the table below.

RGS%2BvaluationYahoo.png


The stock got exciting during February 2017 earnings call. Management announced a deeper commitment to a thoughtful strategic transformation that increases its valuable successful franchise business. It involved selling targeted salons to franchisees, continuing to close underperforming salons and operating a smaller base of profitable company-owned salons. Although in the early stages, Huron Business Advisory is formally engaged in assisting in delivering and speeding up the expanded franchise business model. The initial focus will be on franchising underperforming company-owned SmartStyle salons in Walmarts.

For the recently reported quarter, royalty revenue increased 4.3% and franchisees produced 10 consecutive years of positive same-store sales increases. Management recognized franchisees operate units more successfully based on local knowledge of their market, labor, lower corporate overhead and employee costs. This gives part of the rationale for the strategy shift.

It's important to recognize the much higher market valuations for a successful franchise business. The Supercuts brand alone is worth more than the current valuation. Supercuts for years has been ranked one of the best franchises by Entrepreneur magazine.

(See the 2016 Top Franchises from Entrepreneur's Franchise 500 List.)

The 2017 ranking dropped to 13 after top 5 rankings in prior years.

2016%2BFranchise%2BRankins1.png

Technology investments are paying off as online check-ins through Supercuts.com and the Supercuts app doubled in the last year. Over 2.3 million check-ins occurred in calendar 2016. Digital check-in guests show stronger repeat visit rates. Since fiscal 2012, 1,900 underperforming salons were closed. During this same time, the franchise business grew by adding over 500 salons. Additionally, steps push forward to continue franchising underperforming SmartStyle locations. Another benefit besides the higher valuation for a growing stable franchise business is the increased management focus on fewer company-owned profitable salons.

From the second-quarter earnings call in February 2017: "Although, we are in the early stages of our work with Huron, we're moving forward with a sense of urgency. At this point, it is not yet possible to provide further details on the pace of franchise conversions of the potential financial impact on our results. In future quarters, as our plans are solidified and we gain greater visibility, we expect to provide additional clarity as to the pace and potential impact of our franchise expansion along with enhanced disclosures on the overall profitability and performance of our franchise business."

Back to Regis' investment discovery process.

Warren Buffett (Trades, Portfolio)'s vocal commitment on a company's return on its equity emphasizes its importance in making a successful long-term stock investment. Return on capital succinctly captures operational performance.

Each fragment in the ROE equation has its own underlying drivers, so specific business attributes drive ROE (profitability * productivity * capital structure). Each equation part forms a critical link in driving a higher value. Each measure has its own detail interconnection.

For instance, gross margins and expenses drive profitability. Asset levels, quality and turnover drive productivity, while debt and new capital needs drive capital structure. Then, working back up the value chain, intangibles such as market position, loyalty, brand strength and supply chain strength drive margins and expenses.

ROE components: Profit/Sales * Sales/Assets * Assets/Equity = ROE (Return on Equity). Its also called the DuPont formula (analysis).

A: Profit/Sales = Profit Margins (profitability)

B: Sales/Assets = Asset Turnover (productivity)

C: Asset/Equity (capital structure)

A*B*C = ROE

Profitability (Profit/Sales) financial drivers are gross margins, SGA and operating margins.



Productivity (Sales/Assets) measures asset productivity and is simply the amount of sales generated per asset dollar deployed, for example: sales/AR, sales/inventory, sales/PPE, inventory turnover and fixed asset turnover.

Below are three tables supporting the idea that Regis' are moving in the right direction to drive a higher ROE and a future higher stock price.


Productivity

Productivity%2BMeasures.png

Note the improving asset turnover

Profitability

Profitabilty.png

Note the improving operating margins, net margins, FCF margins, EV/EBITDA

Capital Structure

Capital%2BStructure.png

Note the reduction in share count, debt per share, total liabilities

Catalysts

Continuation of the aggressive share count reduction at favorable prices.

Growth of the franchise business as percentage of total revenues forcing a higher market multiple.

Sale of under performing corporate owned units to existing franchisees or close.

Activist investors Daniel Beltzman of Birch Run Capital owns 10,655,170 shares or 23.02% of the shares outstanding. Beltzman forced changes, took a board seat, removed management, and pushed for Daniel Hanrahan, a former executive at Royal Caribbean Cruises, as CEO.

Long RGS.


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