Description

Background / Overview

RGS has been in turnaround mode for some time, and it has frustrated shareholders as progress seems glacial and accountability seems low, with management habitually referencing highly qualitative targets and shifting themes as they continue to “learn” from past efforts.  Almost four years in, the “new” CEO at times seems to be wearing out his welcome.  Additionally, the stock has been targeted by shorts (and recently the sell side) who believe that their labor model is at high risk in the wake of evolving healthcare benefits and overtime pay regulations. 

However, I believe that at the current price, one is able to pay a fair price for one of the most successful franchise concepts in the market, while creating the following assets for virtually nothing:

• 3,700 owned SmartStyle/Cost Cutters and Supercuts units which are profitable and generating positive same-store sales, following a period of underperformance

• 2,000 owned mall-based value salons which are still in turnaround mode and still generating negative same-store sales

• 700 Regis “premium”, typically mall-based salons, which are losing a small amount of money

• 350 international units, which are losing a smaller amount of money

I never said you were creating Coke, Apple and Google… but free is free.  And these owned units generate $1.8 billion in sales and were once quite profitable, earning a double-digit EBITDA margin, as compared to low single digits today.  Previous write-ups have focused on the likelihood of a turnaround at the owned units.  I’ll focus instead on the franchised units, capital allocation / re-deployment, and what I think this security could be worth.  I also won’t waste time refuting the short case based on labor and healthcare costs; the company has done a decent enough job on this front, and the recent fiasco with the Piper Jaffray analyst’s alarmist short call on the stock, followed by a quick response from RGS and retraction/apology from Piper in the wake of a major error in Piper’s assumptions, is easy enough to read up on.  Ultimately, these cost pressures will affect all of the company’s competitors and are simply not that interesting to me, as they seem to be recovering margin through price increases. 

Strategy

The company’s approach to capital allocation and strategy is as follows:

• Drive the re-franchising of their highly valuable Supercuts franchise concept (2,600 units, of which 59% franchised)

• Drive the share count lower by repurchasing shares at a discount to fair value

• Preserve a clean balance sheet and extend the runway on the valuable option on a turnaround in the 6,800 owned units

• Continue to exit unproductive owned units (particularly the 40% of owned units with mall exposure) as unit economics and lease obligations dictate

Ultimately, I believe they will sell the business if the owned units do not achieve acceptable levels of profitability. 

Franchise Business

The Supercuts brand represents 63% (and growing) of the company’s 2,450 franchised units, and is the company’s largest source of value by far.  In 2010, the brand cracked the top 10 of Entrepreneur’s top 500 franchise rankings, and has been in the top 5 for six of the past seven years.  This year, they reached a new high at #3.  I’m not that familiar with the ranking methodology, or any biases / lack thereof, but it claims to be objective and seems to approach the ranking from the perspective of desirability to the franchisee (extensive financing options and low terminations are viewed positively).  I know it’s an often-cited source in the franchising world, and that Regis is in good company, finishing ahead of proven franchise concepts including Subway, Servpro, McDonald’s, 7-Eleven, Dunkin’ Donuts, Denny’s, Pizza Hut, UPS Store, Taco Bell, etc. 

https://www.entrepreneur.com/franchises/500/2016/

While observers have cited the rapid growth of competing franchised concepts Great Clips and Sport Clips for some time, Supercuts seems to be holding up well.  Supercuts comps dipped negative on the owned side, however Regis’ franchised unit comps have never gone negative. 

Following is a comparison of the three concepts, illustrating both their comparability and Supercuts’ more rapid growth rate and higher ranking:

Supercuts’ increased ad royalty budget has its advantages, as well.  I have noticed all of these TV ads recently, complete with selfies, roller coasters, dogs and a consistent catchy jingle.  This is the first time Supercuts has been able to invest in the brand at this level to my knowledge, which can only help drive market share. 

https://www.supercuts.com/campaigns/supercuts-tv-commercials.html

Following is a table showing Supercuts’ gradual mix shift from owned to franchised units:

Franchise unit growth has recently accelerated from single digits to mid teens, while owned unit closures have also accelerated. 

Meanwhile, overall franchise fees and royalty income has grown between 8-10% annually over the past several years. 

Management claims franchised unit comps have never gone negative, and estimated trends in average unit volumes (which should be depressed by an increasing number of newly franchised units, as well as weighed down by non-Supercuts units) do not dispute this claim.  The following exchange from the company’s most recent earnings call in late April illustrates the current trend in the Supercuts brand. 

Analyst:  “Your growth in comp store sales at your franchisees, can you talk a little bit about that and I'm referring to Supercuts. And how that – and if you are beginning to see a narrowing in the performance gap in terms of revenue per location and a franchise unit versus company-owned?”

CEO:  “We are – both our franchised Supercuts and our company-owned Supercuts are both growing nicely. So we haven't seen a narrowing of the gap because they are both growing. We had another very strong quarter. We don't break out franchise comps, but we had another very strong quarter with our Supercuts franchisees.  And, as you saw, our revenue was up nicely, and that's driven by new stores, but it is also driven by really strong comps. So we haven't narrowed the gap because we are both growing, and so I am happy to see that both are moving in the right direction.”

So having established that RGS is in possession of a highly performing franchised brand, Supercuts, how should we value it?  There are few purely franchised concepts, and given the vast disparity in economics (franchise revenues carry high double-digit margins, whereas owned unit revenues and sales of supplies to franchised units can earn quite low margins), I have found it instructive to strip out owned unit sales (as well as other lower-margin streams such as supply sales to franchisees) in order to arrive at implicit valuations for franchise fee and royalty streams.  I use sales multiples to avoid excessive assumptions.  My assumed sales multiple for the owned unit revenue of each concept roughly acknowledges margin and growth profiles. 

One can debate sales multiples used for owned units, but with restaurant-level margins (not yet burdened by corporate overhead) often in the 15-20% range, and margins on supply chain sales often in the teens, it is difficult to argue for more than 0.5-2.0x revenue multiples for revenues from owned units, depending on margins, quality and growth.  Meanwhile, growing streams of franchise fees and royalties require limited overhead to support and are extremely predictable, subject to the ongoing viability of the franchisee network.  Investors and lenders consider these streams highly valuable, as the implicit valuations in the table above suggest.  Given Supercuts’ status as one of the most successful franchise concepts in the United States, with potential for significant growth, a 10x valuation for RGS’ franchise revenues (simply in line with peers) seems unassuming. 

And if we think RGS’ franchise revenues are worth 10x, then we are paying virtually nothing for their owned business. 

Capital Allocation

RGS’ attitude toward capital allocation is best defined by the company itself in this excerpt from its December 2013 press release:

“The third principle is to deploy capital to its highest and best use.  Once we stabilize the business, the default use of capital will be share repurchases at reasonable prices… As a result, the benchmark for evaluating excess capital deployment will be expected risks and returns associated with purchasing Regis stock.  The preferred use of capital, however, will be to grow the business by reinvesting in salons where expected returns provide attractive rewards relative to risks taken.  All other discretionary projects will be evaluated against the new benchmark of share repurchases.” 

As we can see when we dig into RGS’ recent track record of share repurchases, they have loved the stock at current levels, they have liked it into the mid teens, and they have tapered off around $17 and higher.  These apparent guidelines should be dynamic, as share repurchases below intrinsic value should have created value and effectively raised the prices at which the board finds the stock attractive enough to prioritize over other uses of capital.  Focus on the shaded columns to see prices paid compared to annualized pace of share reduction.  The annual pace during the September and December 2015 quarters was truly prolific at 20-23%, and was accomplished at current price levels (around $13). 

Avoiding dilution has also been a priority, and RGS went to great trouble to cash out a convert that would have added approximately 11m shares to the share count when they refinanced it two years ago.  The conversion price at the time was around $15 a share, again providing some insight into the board’s views on valuation. 

Ultimately, this is both a bet on the jockey and the horse.  By jockey, I do not mean the CEO.  I remain only partially impressed so far and have no idea whether or not he and his team have the ability to turn around the owned units.  But the board, presumably reflecting heavy influence from top shareholder Birch Run, is doing an excellent job optimizing capital and resource allocation.  And as for the horse, I think Supercuts is underappreciated by the market, a sort of “hidden asset” if you will, and the reason the stock is undervalued.  By re-franchising Supercuts as quickly as possible, retiring shares below fair value, and investing prudently in the potential turnaround of the owned business, I believe the range of potential outcomes is highly attractive. 

A quick review of the Premium (Regis) and International segments shows that these segments lose approximately $20 million before even allocating any corporate overhead.  And so if it is determined that either/both of these pieces are just not worth the effort, there should be some add-back to profitability upon their exit.  Not knowing what such exit(s) might cost, I am not pulling these losses out of the owned unit’s overall profitability, but it wouldn’t be crazy to do so.  And noting that segment disclosure only began to break out “North American Premium” (Regis salons) a few years ago suggests that the opportunity to stem these losses is not lost on the company.  From March 2014 10-Q: “During the second quarter of fiscal year 2014, the Company redefined its operating segments to reflect how the chief operating decision maker evaluates the business.” 

Valuation

This is how RGS looks like today, together and in parts:

Based on the above construct, I believe that fair value for RGS is $18-19 without any improvement in the Owned business, representing 40%+ upside. 

But this is what RGS looks like if we assume that management can recover to a 7% EBITDA margin in the Owned business:

And this is where we end up if it takes two years, and we continue to retire shares at increasing prices:

Finally, if the board decides to gives up and sell to private equity, I believe a sponsor could justify paying at least a 20% premium and still create an attractive LBO.  Sketching it out roughly, I could see a sponsor using conservative leverage of 3.5x and making a 2-3x return over 3-5 years assuming continued 10% growth of franchise income and a 5-year path to 7% EBITDA margins on the owned side… or if owned margins never improve from their current depressed state, and money-losing businesses remain a drag, a low/mid-single digit positive IRR would still be possible.  As much as some shareholders might want the board to pursue a sale to private equity, it seems pretty obvious to me why continuing to pursue a turnaround while rapidly retiring shares at cheap prices will be the preferred path as long as it seems viable. 

Catalyst

Continued share reduction

Increased appreciation for growing franchised business, as it becomes a larger piece of the pie

Exit of Premium and/or International segments (absent meaningful progress)

Any margin improvement in owned units

Absent meaningful progress in owned units, the potential sale of business