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Regis Corp has been written up twice on VIC during the last 4 years.   I’ve been following the stock on the sidelines for a while now, and decided to start building a small position last week. 

Note: I’ve been working on writing-up a quick update on the situation for the last few days, and just realized that the message board on the prior submission has been quite active.  Cuyler has touched upon most of the interesting points that initially caught my attention -- insiders buying, as well as the largest holder / board member, Daniel Beltzman of Birch Run Capital, accumulating more shares of their already sizeable position (approximately 1/3 of their portfolio).  The stock price has been steadily climbing for the last couple of weeks on decent volume – which could signal a floor has been established.

Unfortunately for our fellow VIC members who wrote the idea up previously, I don’t believe their thesis has quite played out as they initially hoped for.  RGS has been a painful value trap – thus far, at least.   However, I recommend you read their reports to get up to speed on the market RGS operates in, as well as a basic overview of the business & unit economics.

Optically, the stock has stayed “cheap” all the way down since it was first written up at $17.50 down to today’s price of around $13.00 – all while sporting a low, single digit EBITDA multiple.  The company has been all over the corporate “event” map too: with a failed auction sale to PE suitors, activist involvement, BOD and management changes, and the current ongoing turnaround efforts.

In hindsight, the stock was an ideal short candidate, if one was able to anticipate the continued SSS trends and massive margin erosion of recent years.  In my opinion it was still a tough call to make, considering that historically the company has generated plenty of cash that could, in theory at least, squeeze shorts out through buybacks and dividends.

Call us stubborn.  We still like this as a long.  We are patient, and like situations that are cheap relative to revenue and gross profits; especially when they operate in boring and predictable industries that tend to generate cash even in “nightmare” scenarios like the one RGS has survived in recent years.

Under normal circumstances, the economics of the stores are not bad.  A typical store, on average, may require an investment of 150 – 200k of capital and will produce a steady state of $300 to $400k in revenue with 10 – 18% store level margins.  The franchise business, which is growing and had Supercuts ranked as the 4^th most attractive franchise by Entrepreneur Magazine’s 2014 Franchise 500 issue, also provides an attractive steady royalty fee of ~6% of revenues.

If one looks at historical financials, one can see that in a normal operating environment when the business is running somewhat smoothly, EBITDA and EBIT margins are in the low teens and high single digits respectively.

We believe the business can return to mid to high single digit EBITDA margin.  If we consider that normalized maintenance capex is ~$50 MM, as stated recently by the CFO, we believe RGS will be producing $100 MM in FCF in the not too distant future

If management can execute on their turnaround plan successfully and product and service revenues stabilize and recover, it is not hard to imagine firm level revenues climbing back up to $2,000 MM – and considering comp leverage - a 12% EBITDA margin also seems achievable in this scenario.  This translates to >$200 in pro-forma FCF or 3.5x today’s EV. 

There is no question that this idea has plenty of hair [pun intended]: this isn’t an inherently attractive industry; it is fragmented, saturated, and competitive. 

Moreover, in the last 10 – 15 years, with the success of concepts like Ulta and growth of independent salon operators, traffic and pricing pressure have decimated comps at Regis.  The worst part of all, but good news I guess, is that the deepest wounds for Regis seem to have been self-inflicted -- RGS’s capital allocation record has been abysmal.  Not only has executing their rollup backfired on them, but they’ve also purchased a number of disparate assets that didn’t pan out, only to later divest them as non-core assets.  Despite more than $1 billion in FCF spent in acquiring other businesses in the last 15 years, operating income is down (before write-downs).

The good news is that when things are really really bad, on occasion one can find a diamond in the rough, presuming someone cares enough to do something about it.

The BOD was completely replaced in 2011 / 12 after an activist HF, Starboard Value, initiated and won a proxy fight – which then later triggered more directors being replaced.  The new CEO, Dan Hanrahnan, was brought on in August 2012 and since then has pieced together a new leadership team. 

Progress has been made on some initiatives, albeit slowly.  Non-core assets have been sold, underperforming stores closed, and organizational changes are ongoing.

It is hard to make any sort of projections on what the business will look like in the near future, but over the longer-run, I think it is safe to assume that operating margins revert back somewhere in between where they are now and where they were a few years ago.

Regis has pretty much been in turnaround mode for the better part of three years now.  Hanrahnan hit the ground running and accelerated the implementation of an extensive and exhaustive reengineering plan.  Here are some highlights:

• Simplified operating model.  Regis had accumulated more than 50 brands through acquisitions in the last two decades and each banner operated relatively independently with its own siloed strategy.  It is worth appreciating the scope of this goal considering the growth through M&A it had experienced, from their 10k – “Historically, our salon acquisitions have varied in size from as small as one salon to over one thousand salons. The median acquisition size is approximately ten salons. From fiscal year 1994 to fiscal year 2012, we acquired 8,052 salons, net of franchise buybacks” – During the last couple of years, these businesses have been reorganized around consumer segments rather than brands in an attempt to simplify the overall strategy.
• CRM and POS systems for further integration across the company owned locations.  From the 10-k, “The Company utilizes a point- of- sale (POS) information system to collect daily sales information and guest demographics. Salon employees deposit cash receipts into a local bank account on a daily basis. The POS system sends the amount expected to be deposited to the corporate office, where the amount is reconciled daily with local deposits transferred into a centralized corporate bank account. The guest information is then used to determine effectiveness of promotions and the loyalty base of each salon that feed into salon operational decisions. The information is also used to generate payroll information, monitor salon performance, manage salon staffing and payroll costs, and anticipate industry pricing and staffing trends. The corporate information systems deliver information on product sales to improve its inventory control system, including recommendations for each salon of monthly product replenishments. Recent innovations to increase inventory cycle counts and install high speed connections at each salon are expected to improve stylist productivity and improve guest satisfaction with the checkout process. The goal of information systems is to maximize the overall value to the business while improving the output per dollar spent by implementing cost- effective solutions and services. Management believes that its information systems provide the Company with operational efficiencies as well as advantages in planning and analysis, which are generally not available to competitors. The Company continually reviews and improves its information systems to ensure systems and processes are kept up to date and that they will meet the growing needs of the Company. “
• New operations and HR groups.  The goal for these new groups is to create consistency and standardization in processes, both for quality control in the end product / service, but also to improve reporting and internal communication.  While it all sounds like generic management speak, it is worth noting that RGS was a chaotic mess given the continuous acquisitions from their roll-up strategy have never being fully assimilated from a management perspective.  The HR group will play a critical role in helping shape the performance base culture, at the field and stylist level, that Hanrahnan is attempting to implement – helping lower employee turnover 

The changes haven’t been merely cosmetic [enough with the puns, already].  They have involved a top-to-bottom organizational restructuring that, by and large, is focused on cutting corporate layers from the top and decentralizing the business into a regional model with district / field leaders that are accountable, incentivized and compensated increasingly to drive unit performance.

More importantly, Dan Hanrahnan strikes us as smart, reasonable, articulate, and suitably cautious on how he has approached the changes he is pursuing in the business.  He seems to be practical and value focused, while prioritizing the right efforts to ultimately deliver a better customer experience and create shareholder value. 

In terms of his philosophy around financial and capital allocation decisions, he has expressed on numerous occasions the importance of remaining disciplined – “In terms of my financial values, I'm extremely disciplined, and I'm bringing that discipline to Regis. Every penny will count, all expenses, whether capital or on the P&L, will be justified.”  Their recently announced capital allocation policy is also worth reading (h/t cuyler): http://finance.yahoo.com/news/regis-announces-capital-allocation-policy-215000841.html

None of this obscures the fact that RGS has experienced now almost 3 years of deteriorating comps.  Traffic, prices and stylist retention have played a role – with no clear causal relationship among these three very important factors, it is hard to pinpoint what the diagnosis is, let alone the prescribed solution.  This bleeding hasn’t stopped and it is unclear when it will bottom.

But the fact remains that this is a straightforward industry / business, and franchises are consistently performing better than company-operated stores (generate on average ~$50,000 more in revenue) – which is a sign the business itself isn’t broken, and there is opportunity to improve….besides, how do you break a barber / salon business?  Yes, it is arguably a commodity business likely with some overcapacity, but even so, if managed accordingly, these still produce decent four wall returns.  The product side is less clear, but structurally speaking, nothing has changed that should spell permanent impairment in that business either. 

The longer term fix for both of these businesses IMO lies somewhere in the managerial / incentive structure & design that provides the right amount of carrot and stick, so that it can hire (essentially partner) with the right field managers and stylists that will take more ownership for driving performance.  This is, after all, an entrepreneurial business that is somewhat relationship driven.  The right mix of top down efficiency measures, combined with the right incentive structure, should provide more stability in terms of turnover and better service.

Here is a quote from Dan regarding stylist turnover: “We've got to make sure that they are well focused on training and developing our people. And if we get new stylists in and we're not doing a good job training and developing them, that's when we see them move off to another location. What we will become over time is we will become a company where stylists want to come because of the training and development that we give them. We're not there yet today, and that's an opportunity area for us, to make sure that we deliver the kind of training and development at the stylist level that they need. And then again, it gets back to this idea of leadership. If we've got strong leaders focused on creating a good work environment, we can keep people. So we can track through the organization, and we can see where we've got leader -- where we've got turnover, and it pretty much equates to a leadership development opportunity. And I mentioned in my work that we've done a lot of digging into training and development and the work that's needed so that we can have the kind of leaders that can not only attract good people, but retain them and deliver the kind of results our best operators are giving us.”

Another comment regarding top-quartile operators, that have shown dramatic comp growth in recent quarters: “What I can tell you is that, that group improved. Not only are they growing, but they did improve over the first quarter, and that first quarter of the year was an improvement over the last 6 months of the prior year. And so that's what gives us confidence about the strategy that we have in place, is because the people that are our best operators are showing improvement in the business consistently quarter-on-quarter-on-quarter. And I think that's what your question was, is that -- or are they able to sustain it, and are they able to maintain it? And the answer to that is yes. And we've seen -- we've actually seen the improvement increase. And so it's not like it's a steady state, steady percentage up. But over that time period, we've seen these good operators improving.”….” You think that -- what we've seen is we've seen people getting as high as 25% comps that are executing against the strategy, and that those people are pretty consistent first quarter to second quarter, but that's substantially above what they were in the last 6 months of the prior year, those best operators. And what we're doing is our field leaders are spending a lot of time with those folks, understanding how they've been able to adapt to the strategy so easily and comfortably. And that's how we're developing the training programs for the rest of our people. And for example, we had all of our regional directors and regional VPs in last week and helping to develop the training programs for the field, and then that's the work that they'll go back out, and then they'll train their district leaders. And I'm talking about district, people with 5 to 8 salons that are able to get that kind of traction.”

As I stated in the opening of the write-up, this idea isn’t for everybody, but considering the insider dynamics that signal pretty strong conviction, I think it is worth at least a small bet that they will achieve some success in turning the business around.  I don’t know if this gets sold to a PE or not, as Cuyler believes, but I am willing to own this for a few years to see if this boring business – once and for all – becomes the cash-cow it was destined to become 10 years ago.

Catalyst