Steiner Leisure ("STNR" or the "Company") appears to be the only publicly-traded company that participates in the for-profit, post-secondary industry that has not yet been dislocated.  Although the numerous challenges that confront the for-profit education sector are very well-documented, I do not think those risks are adequately discounted by STNR's current stock price.  I think Steiner's school segment is vulnerable to weakness and that the Company's overall business trends, which benefitted for several years from industry tailwinds, are eroding.  I assert that the Company's financial performance, in 2011-12, is not likely to mirror current "expectations" and therefore the stock will be re-rated to reduced expectations.  I describe below numerous reasons that reinforce my view for why STNR is an attractive short.

If you've ever been on a cruise, it's most likely that the spa was operated by Steiner Leisure.  Steiner provides spa services on more than 150 cruise ships and at 70 land-based spas under several brands (Elemis, Mandara, Chavana, Bliss, and Remede).  In addition, approximately thirty resort and hotel spas are operated under the Company's brands by third parties pursuant to license agreements.  Also, if you ever want to become a massage therapist, you might consider attending one of the seventeen campuses (in nine states) that Steiner operates. 

Steiner's school segment generates approximately 30% of the Company's operating profits, up from just 5% of the mix in 2007, and represented all of the Company's profitability growth in the past few years.  The school segment's operating profit increased by $10.5 million from 2007-2009 versus the spa and product segments which declined by $7.3 million over that same period.  Some of the school segment growth was generated from acquisitions of Utah College of Massage Therapy, adding seven campuses in 2006, and Connecticut Center for Massage Therapy, adding three campuses in 2009.  Much of the school segment growth is evidenced by an operating profit margin that increased from 5% in 2007 to almost 21% in 2009.  For the twelve months ended September 2010, Steiner's school segment operating margin was 24.6%.  For context, this LTM operating margin compares with the broader for-profit education peer group at less than 21%.  I do not envision the current favorable margin at Steiner's school segment to be sustainable and neither do I envision the peer group's LTM margin to be sustainable for many reasons that are already well-documented issues and concerns that confront the for-profit education industry.  However, in regards to the peer group, since the issues are so well-documented, there are some plausible arguments that can be made (although that is not what I am trying to assert) that the for-profit education sector, trading at 11x NTM earnings of mostly reduced estimates, is already discounting the numerous valid industry and regulatory concerns. 

In the past few years, Steiner has greatly benefited from the overall growth in the spa industry.  In 1994, the U.S. spa industry was just beginning to blossom.  There were approximately 3,000 spa locations then.  In 2004, there were over 12,000.  According to the International Spa Association, the spa industry now generates over $12B in revenues and there are currently over 20,000 spas in the U.S.  Steiner has capitalized upon this industry growth in addition to the overall growth in the cruise industry.  However, after growing quickly for several years, some of the industry's tailwinds have recently become headwinds and the Company's main source of recent growth-its school segment-is vulnerable to increased regulation, increased competition and less favorable overall spa industry growth dynamics.  Although many of the issues pertaining to the post-secondary school sector have become well-documented, these issues are not as likely to be discounted in STNR's equity as the "pure play" companies.  I do not think that the growth prospects for Steiner's school segment have yet to be adequately reduced nor do I believe the appropriate valuation that should be accorded to the school segment and the rest of the business is appropriately reflected by the current stock price.

Summary Description

As of February 11, 2010, the Company served 126 cruise ships representing thirteen cruise lines and operated 50 resort spas, 11 urban hotel spas, and 6 day spas.    There are currently more based on some acquisitions and operating agreements announced during the year including the acquisition of Onboard Spa which served twenty ships.  Of the 126 cruise ships then-served earlier last year, 75 of the ships were part of Carnival Cruise Lines ("CCL") across a variety of line cruise brands (including Costa, Holland America, Princess, and Seabourn), and 31 of the ships were part of Royal Caribbean ("RCL") across a variety of cruise line brands (including Azamara and Celebrity).  The land-based spas are primarily operated as either Mandara or Bliss brands.  Steiner Leisure purchased Bliss, at the end of 2009, for $90M in cash from Starwood.  The purchase included both the Bliss and Laboratoire brands as well as an arrangement whereby Steiner Leisure would be the exclusive operator of spas located within Starwood's W and St. Regis branded hotels.  

Summary Financials

Pre-Acquisition of Bliss by Segment

2007                2008                2009   

Revenue

Spa Opns            416.4               417.1               368.1              

Products             96.7                 96.3                 83.3

Schools               46.0                 50.6                 61.6

Other                  (29.8)               (23.2)               (22.4)

   Total               529.2               540.8               490.6

   % growth                                2.2%                (9.3%)

Oper Income

Spa Opns            38.0                 32.8                 28.9

   Margin %        9.1%                7.9%                7.9%

Products             5.1                   5.6                   6.9

   Margin %        5.3%                5.8%                8.3%

Schools               2.3                   4.7                   12.8

   Margin %        5.0%                9.3%                20.8%

Other                  2.3                   7.2                   (5.5)

   Total               47.7                 50.3                 43.1

EBITDA           60.1                 62.3                 53.9

Pro Forma Overall Company for Acquisition of Bliss (as of 1/1/2007)

               2007                2008                2009                10E                 11E                 12E

Rev         640                  647                  573                  610                  645                  681

EBIT      55                    51                    42                    53                    59                    68

EBITDA   68                    63                    53                    67                    74                    83

Note:  Estimates above are current consensus

My analysis, primarily based on a different perspective at the school segment, leads me to model estimates for 2011E and 2012E as follows:

                                                                                       Revenue          601                  626

                                                                                       EBIT               51                    53

                                                                                       EBITDA         66                    68

Selected Bearish Arguments

Steiner's School Segment is Vulnerable to Regulatory Scrutiny

There are roughly 1,300 massage therapy post-secondary schools, college programs, and training programs throughout the country. Steiner owns and operates five post-secondary schools (comprised of a total of 17 campuses).  As of February 11, 2010, there were a total of 4,483 students attending its schools.  Although the schools represent ~11% of overall Company revenue, the school segment accounts for ~30% of operating profit which is vulnerable to looming regulatory policies to be announced by the Department of Education.  From 2007-2009, the operating profit in the school segment grew by $10.5M while the operating profit in the spa and product segments declined by $7.3M.  Steiner's school revenue has grown quickly, driven by the acquisitions as well as by organic growth associated with an increase in students attracted to the growing massage industry.  However, the pace of massage industry growth, and therefore employment opportunities, is not expected to be as strong as the recent past.   

The school segment revenues, which consist almost entirely of student tuition payments, are derived to a significant extent from the proceeds of loans issued under the DOE's Title IV program.  Although not reflected by Steiner's stock price, uncertainty continues to hinder the group.  Urgency for dealing with 90/10 increases this year given the July 2011 expiration of the exclusion of incremental unsubsidized Stafford Loans made available through the Ensuring Continued Access to Student Loans Act and the adverse interaction with Gainful Employment ("GE") language is forthcoming.  While there is still no defined timetable for issuance of the final GE metric rule, it is widely anticipated to be a Q1 event. 

It is notable that four of Steiner's 17 campuses fall under the Department of Education's threshold for a loan repayment rate of 45%.  Of those four, three are between 40-45%, with the outlier at 29%.  On average, Steiner's students are carrying a median debt load of almost $6,000, with an average repayment rate of 51%.  For context, this is favorable relative to the ~$11,000 debt load and 37% repayment rate for the public for-profit.  It is especially favorable when compared to a more direct comparable, Everest College owned by Corinthian, which competes with Steiner to attract/educate/employ massage therapist students.  The debt load at Everest is ~$6,750 and the repayment rate is just 22%.  Although Steiner's current metrics appear relatively attractive, the overarching regulatory framework (even if sanguine relative to expectations) compounded by intensified competition to attract the best students will make it more difficult for Steiner to achieve the top-line and margin growth that its school segment has generated and perhaps the market has discounted to expect going-forward.  The revenue growth expectation in the for-profit education sector has largely been reduced to ~3% but current expectations at Steiner's school segment are more than double and without the magnitude of margin compression that I anticipate. 

It is worth noting that the school segment incurred two resignations by the school division leader, in August 2006 and in December 2007.  These resignations occurred when the segment margin was just 8.7% and 5.0%.  It is possible that the resignations were forced because of poor margin performance that have ultimately improved to 24.6% (LTM) under current leadership but it also makes me wonder if recent margin performance was derived more aggressively.

A Key Driver of Steiner's Revenue-Cruise Ship Capacity Growth-is Slowing

Although much of the thesis has thus far been premised on the school segment, the legacy and also still the core business is the cruise-based spa operation.  Steiner has developed a dominant niche position as a service provider operating spas across almost all the major cruise lines.  The Company has grown organically and through strategically attractive bolt-on acquisitions of its competition including the most recently completed transaction with Onboard Spa which expands Steiner's relationship with P&O Cruises, a division of Carnival.  In the past few years, most of the Company's organic cruise spa growth was not derived from increased utilization or pricing (both are not likely to rise by much if at all) but rather from the overall increase in new cruise ships and therefore growth in capacity for which Steiner did benefit through absorption.  This was a tailwind benefit but will not be such in the near future.  Cruise ship deliveries are slowing over the next few years.  Although cruise capacity growth had been high, it will taper off as both Carnival Cruise and Royal Caribbean become less active.  After capacity growth of ~9% and 5.5% in 2008 and 2009 at CCL and ~5% in each of those years at RCL, capacity growth in 2010 is estimated at ~7.5% at CCL and 11% at RCL.  Estimates for capacity growth in 2011-2014 at Carnival are, on an approximate basis, 5.5%, 4.5%, 4%, and 4%.  Estimates for Royal are 7%, 2%, 3%, and 0%.  The overall cruise industry is estimated to have grown capacity by over 8% in 2010 but growth for 2011-2014 is estimated at just 3.5%, 5.5%, 3%, and 2.5%.

Structural Challenges Causing Core Spa Operations Margin to Erode

In 2007, Steiner generated an operating margin of 9.1% in the spa operations segment.  In both 2008 and 2009, the operating margin was just 7.9%.  For the nine months ended September 2010, the spa operating margin was just 6.9%, down from 8.1% for the same period in 2009.  Although one might submit an argument that margin degradation is the result of lower revenue, this is not the case since revenue grew between 2007 and 2008.  Moreover, the 120 basis point decline in margin for the most recently reported nine months was despite the top-line growth in spa operations of more than 19.5%.  There are structural challenges that confront Steiner Leisure to grow the margin of its core business.

1.      There is an increasing number of competitive spa alternatives (one such example 600-unit Massage Envy) which inherently elevates the demand for massage therapists who have consequently been able to extract more from their employer.

2.      The amount that Steiner typically pays to cruise lines and land-based venues increases upon entering into renewals of agreements.  The terms with cruise lines range from 1-6 years.  The terms with land-based spas range from 3-20 years.  At the end of 2009, the Company's guaranteed total minimum payment to the cruise lines was estimated to rise by 3.5%.

3.      Within the cruise line spa segment, the revenue per staff per day has been affected by the increasing requirements of cruise lines which compel vendors like Steiner to place additional non-revenue producing staff on ships with large spas to improve the likelihood of a high-quality guest experience.  For the nine months ended September 2010, Steiner's staff per ship increased by over 8% from the nine-month period in 2008.  Furthermore, this compares to ~10% decline in revenue per staff day over that same 2008-2010 period across the ship segment.  This data is clearly evidence of part of the cause for the spa operation margin compression.

4.      Some margin degradation can be ascribed to higher fuel costs which ultimately lead to higher transportation costs.  Steiner depends on commercial airlines for the transportation of its shipboard employees to and from the ships the Company serves.  Increased transportation costs associated with increased fuel costs (as evidenced in 2008, 2010, and currently) add to the costs for delivering both the personnel and products of Steiner to the ships it serves.

5.      The Company does not influence the type of passengers who travel on the cruise ships it serves.  In the past few years, the cruise industry has added substantial capacity and although the cruise industry has thus far driven strong utilization, especially given the economic circumstances, the cruise industry is increasingly targeting passengers who are directing their on-board per cap spending to numerous other activities, including those which the cruise company wholly-owns with full incentives, and choosing lower-margin services when embracing the cruise-base spa.

6.      Furthermore, to attract more guests, the cruise industry has developed itineraries that include more time visiting different destinations and less day-time at sea.  When cruise ships are in port, Steiner's cruise-based spas are adversely affected.  The Company engages in more promotion to attract guests when in port.  Also, in the past couple of years, there are more cruise offerings that are longer in duration and that call on more exotic ports.  Such cruises generally generate lower revenues for Steiner than shorter cruises as well as cruises that call on more common destinations.

Numerous Land-based Alternatives Growing

Getting a massage can cost $100 or more, which in itself can induce stress.  Despite the highly-discretionary nature of massage therapy, the industry has grown substantially in the past few years.  People have embraced the notion that massages can help them reduce serious stress issues.  A recent study by Cedars-Sinai Medical Center in Los Angeles identified that just 45 minutes of deep Swedish massage results in a significant decrease in the stress hormone cortisol, which causes stress, and arginine vasopressin, which can elevate cortisol.  The study also showed a rise in white blood cells, which aid the immune response.  As noted above, one such alternative is the fast-growing Massage Envy, which offers introductory one hour massage sessions for just $39.  There is indeed a substantial premium that should be accorded to the quality (whether perceived or real) of a spa like Steiner's Bliss but the same massage is priced at Bliss for $115.  The customer segment for Massage Envy is primarily different and their business model is focused on monthly membership but the magnitude of pricing disparity does render issues for much pricing power within the Steiner spa segment.  Moreover, the magnitude of spa openings does reinforce the assertion that the massage therapist is commanding more for their services.  It is worth noting that the magnitude of spa openings has also been among the drivers for Steiner's success in the school segment.  With more employment opportunities available for massage therapists, as evidenced by the 9% CAGR of spa unit growth in North America from 2004-2010, this industry tailwind drove lots of interested applicants and attractive job prospects.  However, that pace of spa unit growth is slowing and the intensity of competition is being elevated as schools expand their "health" and "beauty" programs to address the massage school opportunity.

Cruise-based Spa Employment is Unappealing

Shipboard employees typically are employed pursuant to agreements with terms of nine months.  As learned from conducting interviews of twenty-five massage therapists who worked on cruise-based spas, the majority of such therapists wouldn't do it again, in spite of the romanticized notion of getting to travel.  Several of them did not fulfill their nine-month agreement because of the harsh working conditions and especially relative to better alternatives across the growth in the land-based spa universe.  The main issue of discontent cited by the therapists was the high-pressure for selling spa/skin care products.  The other most frequently cited issue was feeling isolated.  The accommodations are smaller than a dorm room and shared with others.  Furthermore, therapists are often expected to work at least twelve hour shifts and the pay isn't very good.  One therapist suggested that before signing-on, potential candidates should spend a few weeks scheduling themselves for ten massages per day to see if they can maintain the pace while living in a tightly packed room with three other people.  The notion of enjoying leisure time in different ports is compromised by the need to work to accommodate the cruise ship specials targeted towards guests who have chosen not to go on-shore excursions.  Nevertheless, there is no doubt that Steiner is advantaged towards staffing its cruise-based spa operations as well as its land-based operations.  There is of course some benefit derived from Steiner's vertical integration (i.e., attract student/educate student/employ alumni).      

Stretching for Growth by Overpaying for Bliss

Over the past few years, Steiner has pursued numerous bolt-on acquisitions that appear to be strategically attractive.  However, I believe the price paid to acquire Bliss in late 2009 is demonstrative of overpaying.  I say this despite recognizing the fact that management highlighted the transaction being accretive by $.05-.10 in 2010 and the market applauded the transaction at the time, bidding the stock up by 7.5% over two days.  The headline price paid was $100 million but the real price (net of cash acquired) was $90 million.  Bliss is both a spa and product business.  At the time of acquisition, Bliss operated eighteen spas.  Beauty retailer Sephora represented almost 30% of Bliss sales.  In connection with the acquisition, Bliss and Remede spas and amenities will remain exclusive to Starwood in the hotel category at W Hotels and St. Regis Hotels, respectively.  In recording the transaction, Steiner accounted for goodwill and intangibles to be more than 75% of the price paid.  For the years 2007-2009 (the transaction closed end of 2009), Bliss generated EBIT of $7.4, $0.2, and $(1.3) million, respectively, on revenue of $110.7, $106.5, and $82.2 million, respectively.  The EBIT multiple paid, based on the three year Bliss EBIT average, was ~43x.  Based on the Bliss peak of $7.4 million, the 12.2x EBIT multiple is still expensive for a business that generated just 6.7% margin at its peak.  It could be evidence of the Board and management implicitly acknowledging cracks in the legacy/core cruise-based business and vulnerabilities at the school segment, as described.    

Substantial Insider Selling in Both Breadth and Depth

In the past twelve months, insiders sold $12 million of stock.  In the past twenty-four months, insiders sold $22 million of stock.  No insider has purchased stock since 2003 when the stock traded at ~$15.  Insiders have sold recently between $38-47.  Insider alignment is low.  Other than the Chairman and CEO, there are no insiders owning more than 100,000 shares.  The aggregate ownership of the non-insider Directors amounts to less than 25,000 shares.  The breadth and depth of recent insider selling should not provide current or prospective investors with the requisite confidence that management views its current equity value to be attractive.  Shown below are the insiders (by title) who have sold in the past year as well as the magnitude of their holdings sold over that period.

• SVP Mandara Spa Resort Division sold ~100%
• General Counsel sold ~80%
• Director (Preston) sold ~60%
• COO Maritime sold ~60%
• CFO sold ~55%
• VP Finance & CAO sold ~40%
• MD Steiner Training sold ~40%
• CEO (owns less than 1%) sold ~30%
• MD Products sold ~30%
• Chairman sold ~10%

Insular Board with Inadequate Equity Alignment is Additional Red Flag

Although the four non-insiders of Steiner's seven-member Board are "non-insiders" by the strict definition, I question the quality of the Board's oversight when three of the four non-insiders were previously being compensated by the Company for audit, tax, and investment banking services.  Director Preston was a Partner at Andersen providing Tax services to Steiner from 1995-2002; Director Dickins was the Partner at Andersen providing Audit Services to Steiner from 1996-2002; and Director Harris was a Managing Director with ABN/ING Furman Selz who provided investment banking services to Steiner from 1996-2001.  Furthermore, the quality of the "non-insider" Directors' aligned interest with Steiner's non-management shareholders is weak at less than 25,000 shares in total.  Given the context of this insular Board, I wonder if there are any aggressive or questionable business practices that exist, even when I read about disclosed related-party transactions that include the employment of the Chairman's son-in-law as a Managing Director in the UK as well as the rental of a building owned by the Chairman.  I am not asserting anything specific that results from my perception that Steiner's Board is highly insular but I do ascribe some weight to it in my overarching short thesis.  I especially deem the observation to be relevant because of the increased scrutiny and regulation of the overall for-profit education sector which has been the primary driver of the Company's recent growth.  It is also worth noting that two Directors, Jonathan Mariner and Charles Finkelstein, resigned in April 2006 and October 2008, effective immediately, after nine and eleven years, respectively.  From what I can discern, there were no related party issues with either of them (as opposed to those that replaced them) that existed prior or during their terms.     

Some Risk Management to Protect Portfolio from Travel-related Risks

Every portfolio is unfortunately exposed to the fat-tail risk that comes with terrorism but this is amplified among travel-related companies.  I ascribe some additional sizing to a STNR short providing portfolio protection, even to a small extent, against the occurrence of a potential 9/11-like event that challenges the travel/leisure industry.  As a small anecdote for how the Company can be impacted by travel-related issues, Steiner has highlighted some weakness in the past being ascribed to issues associated with weather and/or terrorist-related activities within Indonesia, a country where Steiner operated 10% of its hotel-based spas as of the last 10-K.  It is horrible to envision anything similar to 9/11 but in acknowledging the probability is more than zero of travel-related terrorism, I deem the STNR short provides a measure of risk management to that risk spectrum.  As a result of 9/11, STNR declined by ~63% until bottoming on Sept 21, 2001.   The S&P declined by less than 14% over that same time period.

Potential for Removal of Favorable Tax Treatment from Possible Adverse Changes in U.S. or Foreign Tax Laws

In 2009, the Company's effective income tax rate was just 11.7%.  Similar to the tax benefits enjoyed by the cruise lines from conducting business at sea, Steiner enjoys a favorable tax rate.  There was a recent NYT article that commented on this tax loophole enjoyed by the cruise companies and there is much described in Steiner's risk factors to peruse for more elaboration of this topic of risk.  In short, Steiner's legacy business for operating cruise-based spas is becoming a smaller component of the mix and there are some considerations for how products and services are allocated towards benefitting from the "loophole" for operating at sea.  Steiner's 10-K highlights the possibility of the Company being responsible for paying taxes of up to 35% on Steiner Transocean earnings prior to 2007.  I have spoken with a tax lawyer about this risk factor and cannot ascribe an appropriate probability to assess this risk but it would be a significant set-back for the Company and is simply another factor that I assert is not currently discounted by Steiner's stock price. 

Short Thesis Target

I frame this short thesis can provide ~20% return in twelve months or less.  The Company reports tomorrow and more clarity will develop that validates or refutes components of my thesis.  I do not anticipate the short working immediately (they rarely do) and therefore size accordingly.  My $36.25 target is derived from my reduced level of expectations relative to consensus coupled with some re-rating of the multiple.  The Company is currently trading at 10x LTM EBITDA, 12.5x LTM EBIT, and 16x 2010E EPS.  My target is derived assuming the stock trades at 8x estimated EBITDA and 10x estimated EBIT; this compares to the current multiples (8-9x EBITDA and 10-11x EBIT) versus higher consensus estimates.

Selected Bullish Arguments / Risk to Short Considerations

1.      Domination of niche cruise-base spa segment.  Steiner has developed competitive advantages through its service track record and through numerous acquisitions has raised the switching costs for the cruise lines.  However, margins have been in decline and there are structural reasons that challenge improvements anytime soon.

2.      School segment has exhibited substantial top-line and bottom-line growth.  This is undoubtedly true but as elaborated upon above I describe numerous reasons why the pace of growth is unlikely to be sustainable and there are some questions of the quality of this growth.

3.      Low capital intensity.  The Company has generated lots of FCF and its business model as a service provider empowers this to continue.  In 2006 and 2007, Steiner generated ~$40M of FCF in each year.  In 2008 and 2009, FCF was substantially higher at ~$60M in each year.  This is significant and some of it is derived from the favorable tax treatment that could get compromised but it is also recently derived from capital spent at less than half of D&A in 2008 and 2009.  It was 150% or more in the prior two years.

4.      Attractive balance sheet.  The Company enjoys a position of financial flexibility coupled with attractive FCF generation. 

5.      Potential for Bliss acquisition to accelerate new path of growth in product segment.