This Stock Has Already Taken a Haircut, Now It's Time to Buy

Ted is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Even great businesses can be run into the ground if the wrong people are in charge; that's what happened at Regis Corporation (NYSE: RGS), a publicly-owned hair salon operator based in North America. Regis had been a steady and predictable salon operator for decades until 2007, when operating expenses suddenly shot through the roof under the guidance of former CEO Paul Finkelstein. Finkelstein resigned in February 2012 and activist hedge fund Starboard Value is turning the company around after winning a proxy contest at the last annual meeting. Insiders and 10% owners have bought a whopping $127 million worth of stock over the last three months, an indication that Regis's fortunes may be about to change.

Business Overview

Regis's primary business consists of its North American salons. The company has over 9,300 branded salons that cater to the middle market, with an average ticket price of $17-$20 (includes service and products). Store concepts include well-known brands such as Supercuts, Mastercuts, SmartStyle, and Regis Salons. Location is the most important factor in determining the success of a salon. Regis' good reputation and strong balance sheet allows it to secure prime leases for company-owned salons.

Regis also operates 398 salons in the United Kingdom. International concepts include Regis, Supercuts, and Sassoon.

The company also owns Hair Club for Men and Women, the largest U.S. provider of hair restoration services. Hair Club's EBITDA margins are roughly double that of the North American salons, and it has a predictable, annuity-like revenue stream. It currently has a 5% share of the domestic market.

Finally, Regis owns a 55% non-controlling interest in Empire Education Group, the largest beauty school operator in North America. EEG has been profitable, but it is not consolidated in Regis's financial statements.

Running the Company into the Ground

Why does a North American salon operator own salons in the U.K., an unrelated hair restoration service, and a beauty school? Because of the former CEO's singular pursuit of revenue growth at the expense of profits.

The salon industry is large and fragmented. Regis's 4% market share is the largest in the $50 billion domestic market, so pricing is set by countless competitors. Thus, companies in this industry maximize profits by making operations as lean and efficient as possible.

The graph below shows Regis's operating margin and net margin relative to its gross margin.

 

 

Hair salons are normally predictable businesses. The unpredictability of Regis's recent results is due to a combination of the extreme price sensitivity of customers during the Great Recession and the company's rising operating expenses relative to gross profits (see graph below). Regis's operating costs have increased significantly over the past several years, but gross margins have remained stable even through the recession.

Regis's rising expenses are due to poor capital allocation by former CEO Paul Finkelstein. Finkelstein resigned in February following years of overspending on acquisitions, investing in non-core assets, and getting paid millions amid deteriorating fundamentals.

On September 15, 2011, Starboard Value announced a 5.1% stake in Regis. The hedge fund has since nominated three directors to the eight-member board and has proposed a plan to reduce operating expenses and sell non-core assets. Regis's future prospects are brightest in a scenario in which Starboard is able to implement its proposals without significant resistance from the board. Since the October 2011 annual meeting, the activist fund has forced the resignation of Paul Finkelstein along with company president Randy Pearce. In addition, the company has announced plans to sell Hair Club in Q1 2013. Starboard apparently has been effective at executing its plan thus far.

Financial Analysis

An investment in Regis will be successful if two things occur: (1) Regis restores its return on sales to historical levels, and (2) the investor pays a low price relative to sales. The ROS is what will reward the investor for buying at a certain P/S ratio.

Return on Sales / Price-to-Sales = Return on Stock Purchase

Regis averaged a 2.5% ROS over the last decade; this is even worse than Ulta Salon (NASDAQ: ULTA), which is in high-growth mode and not concerned about profits. As Regis's operating expenses started to rise significantly in fiscal 2007, ROS to plummeted.

However, if operating expenses has remained at pre-2007 levels, Regis would have averaged a 4.74% ROS. The stock currently trades at a price-to-sales ratio of .43 based on trailing twelve months sales.

4.74% / .43 = 11.02%

Essentially, an investor who buys the stock at .43x TTM sales is paying 9x "normal" earnings (100 / 11.02 = 9) assuming operating expenses return to pre-2007 historical averages and revenues are stagnant. Whether or not Regis can return to pre-2007 expense ratios depends on Starboard's ability to cut costs.

One way Starboard is reducing costs is by eliminating redundancies in the management structure. Currently, managers are assigned to specific brand concepts rather than to regions.  This requires Regis to employ separate area managers and regional managers for each concept, rather than employing a single layer of middle management for each region.  A unified field operation would not only be more cost-effective, but managers would also be better equipped to share best practices and drive profitability enhancements throughout the network.

In addition, Starboard has reigned in executive compensation and is revamping incentive to align management's interest with those of shareholders.

Furthermore, Starboard is pressuring Regis to sell the international salons and Empire Education Group in addition to the already-announced sale of Hair Club. The activist fund believes that the unconsolidated entities are not being properly valued by the market and that the non-core assets are a distraction of Regis's salon business in North America.

Each of these things work toward solving Regis's key problem, which is converting gross profit into earnings. Given that Starboard is focusing on eliminating the bloated cost structure and reducing inefficiencies, it is likely that Regis will achieve pre-2007 expense ratios with the next two to three years.

Valuation

So, is paying 9x normalized earnings a good deal for an investor? Regis has historically trades at 15-20x earnings and at least .7-1x sales. Based on a P/E of 15, Regis should sell for $27.28 per share ($38.38 per share in LTM sales x 4.74% ROS x 15 P/E).

In addition, Regis has maintained steady and predictable free cash flow even through the recession. Since 2002, Regis's FCF margin has averaged 5.68% with a coefficient of variation of just .16 (which is lower than even Microsoft's). Real FCF per share has averaged $2.34 (in today's shares) over the same period. In addition, FCF has been consistently higher than net income over the past decade.

Consider:

  • An investor with a 10% cost of equity should be willing to pay $23.40 per share base on average FCF of $2.34
  • At a recent market price of $16.60 per share, the market offers a 14% yield on normalized FCF
  • Applying the 5.68% FCF margin to LTM sales of $38.38 per share gives a valuation of $21.80 per share using a 10% cost of equity

Regis appears to be worth at least $22 per share and is likely worth somewhere in the high-twenties per share assuming sales rebound.

Concluding Thoughts

Regis competes in a simple industry. Customers do not care which "concept" they get their hair cut at; they simply want convenient locations and reasonable prices. Prices are set by the market, so the value is in the locations. Cutting costs in this industry is not rocket science: spend on prime leases, cut everything else. That is how you turn gross profits into net income.

A salon operator does not need to own beauty schools or hair restoration centers. Regis needs to focus only on the salons, and on running them efficiently; all other assets are a distraction. Regis only has a 4% share of the market in North America, so it can focus on nothing but salons and keep growing for a long time. Starboard understands this.

There is nothing to turn around at Regis except for the costs. The value is in the locations and the ability to serve customers. That has not been impaired. This is not like turning around Dell or HP, it's about selling the exact same service in the exact same places in the exact same way while increasing the efficiency with which gross profits turn into earnings per share. It's the perfect job for an activist investor.

The two things I ask myself when making an investment decision are:

            (1) Is the company cheap based on historical operations?

            (2) Is the company likely to do better in the future than it has in the past?

Regis looks cheap based on historical operations. It has an earnings yield of 11% and a FCF yield of 14% based on historical margins.

It seems likely that Regis will perform better in the future. With Starboard agitating for cost reductions and a resumed focus on the salon business, it is difficult to imagine Regis doing worse in the next decade than it did in the previous one. With economies of scale unmatched by any competitor in North America, Regis will prosper under the guidance of new management focused on cutting costs.


titans8904 has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. Motley Fool newsletter services recommend Ulta Salon, Cosmetics & Fragrance. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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