|Shares Out. (in M):||40||P/E||0||0|
|Market Cap (in $M):||660||P/FCF||0||0|
|Net Debt (in $M):||37||EBIT||0||0|
|Borrow Cost:||General Collateral|
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Regis Corp. (“Regis”, “RGS”, or the “Company”) is an owner-operator and franchisor of one of the largest hair salon chains in the US, operating 3,376 company-owned stores and 4,375 franchised stores, predominantly under the Supercuts, Signature Style and SmartStyle/Cost Cutters brands.
Regis has been a perpetual turnaround over the past decade with a revolving door of management teams and activist investors who have attempted to turnaround a brand facing secular decline and intense competitive pressures. After reaching a ten-year low in 2017, a new management team under a consultant turned CEO Hugh Sawyer, has attracted institutional investor interest, elevating the stock price under a refranchising strategy. This strategy has led to the sale of Regis stores at a low multiple of EBITDA with the proceeds used to buy back stock at an elevated valuation.
After completing a deep dive of Regis’ financial statements and franchisee disclosure documents, we believe that the turnaround is a façade based on aggressive accounting and financial engineering versus true operational improvements. Obscured financial results have led to Management bonuses as their incentives favor a focus on short-term adjusted EBITDA at what we believe is the expense of the long-term picture. Meanwhile, the Company’s financials continue to falter as traffic continues its downward spiral and free cash flow remains negative.
Ultimately Regis’ poor fundamental outlook, lack of tackling its significant traffic issues, aggressive accounting tactics and irrational valuation will lead to its undoing as we expect the share price to take a 50% to 70% haircut over the coming year.
Red Flag #1: Dubious Franchisee Sale Designed to Dress up the Financial Statements
On October 21, 2017, RGS closed one its first large refranchising transactions whereby management transferred 858 U.S. mall-based locations and 250 UK salons to “The Beautiful Group” or “TBG”, a private equity backed entity. Regis received little to no consideration for the deal outside of TBG’s assumption of liabilities and working capital adjustments. Regis also retained liability for the guarantee of operating leases for certain TBG salons. The fact that Regis gave TBG away for little to no consideration gives you a sense for just how ugly of a business this is.
RGS has a TSA agreement in place to provide services and theoretically divested an EBITDA loss generating segment. TBG is material in size, representing over ~10% of the salon base.
Less than six months after deal close, it became evident that the TBG entity was struggling out the gate as RGS was forced to take a $11.7MM reserve against working capital/prepaid rent payments associated with the original transaction as well as reclassifying $8MM of A/R to a long-term note. As 2018 progressed, the TBG’s financials deteriorated along with material risk factor disclosure changes with each subsequent quarter, for once quantifying the operating lease liability that Regis is on the hook for ($64.8MM as of 3/31/19 10-Q). Moreover, TBG is on the brink of insolvency considering (1) TBG international has already filed for insolvency hearings in the UK whereby landlords have filed challenges noting material irregularities; and (2) a $20.7MM write-off by RGS relating to the U.S. mall business 2019 inventory sales into TBG.
Source: RGS 3/31/19 10-Q Pg. 41 and Pg. 32)
Over the six quarters of TBG ownership of these former RGS salons, the Company recognized ~$38.4MM of revenues, mainly for inventory purchases at low to no margin to Regis, yet recorded an $11.7MM charge in 3/31/18 and a $20.7MM charge as of 3/ 31/19. Hence it is quite clear to us that the TBG transaction appears to be a “phantom” sale as (1) RGS received little to no consideration from the “sale”; (2) instead of generating significant revenues from TBG they are effectively providing the life support to TBG through “free” working capital; and (3) RGS is still on the hook for a large portion of TBG’s lease liabilities. It is safe to conclude that TBG is generating significant EBITDA losses and the 3/31 10-Q language bluntly summarizes the dire situation:
“TBG's business has continued to decline. The Company continues to have conversations with TBG focused on how to assist TBG with its cash flow and operational needs.”
We believe language that came out in the 3/31/19 10-Q damaged Management’s credibility from the Jan 2019 call, especially after the $20.7MM charge-off which occurred the following quarter:
Rory A. Held
All right, appreciate it. And one final one, so The Beautiful Group situation seems like it's kind of deteriorated over the last 6 months. Would you guys hazard a guess, in like, what the chances are that these stores may come back to?
Hugh E. Sawyer
Well, the original thesis behind The Beautiful Group was a risk transfer model of the least exposure to The Beautiful Group. I'm not certain it would be accurate to state that things have eroded in the last 6 months. In fact, we might have a different view of that. And we -- if I've said on other calls if it were to happen that some of these locations came back to you, that's -- came back to us. We're in the business of operating salons and we knew when we did the transition that it was hypothetically possible some of them would come back. So we have a number of mitigating options in the original transaction documents that reduce our exposure. And furthermore, we're in the business of operating salons. And so if it happens, we'll cross that bridge when we come to it, but I don't see anything in the data that convinces me that our risk has increased. In fact, quite the contrary since the transaction was consummated, our risk has been materially induced -- reduced as it relates to the overall lease exposure.
Rory A. Held
Okay, yes, I'm just -- we don't get -- all we get is what's in the sort of risk factor section and the language there has changed each quarter. So it just seems like it's worse.
Hugh E. Sawyer
Yes, we're trying to be more -- actually, it has improved since the day of the transaction.
Source: RGS 2Q 2019 Earnings Call
We find multiple issues with this transaction which we view as dubious and a ploy to enrich management per the proxy. The drivers for the transaction appear to be driven by management incentives as we find two potential conflicts of interest/issues with the transaction. First, Per the closure of the transaction as written in the Company’s proxy, a portion of the Management’s annual non-equity cash incentive compensation was predicated upon the closure of the deal. Hence it was in management’s interest to dispose of these assets no matter the terms or impact down the road. Secondly, Huron Consulting (The CEO’s former employer) served as the advisor on the transaction in addition to their role related to the compensation plan per the proxy.
Source: https://www.sec.gov/Archives/edgar/data/716643/000114036118037937/bp11671x1_def14a.htm (see pages 20,26 for TBG and 27 for Huron).
“It's important to remember that the value created in the transaction with The Beautiful Group has always been through the risk transfer of our mall-based lease exposure. And since the execution of this transaction in October 2017, the company's mall-based lease exposure has been materially reduced.”
On the most recent call (1Q 2019), management once again pointed out the “benefits” of the transaction despite the continued write offs. We believe the above comments are false as supported by the company’s financial statements. Ultimately Regis recognizes revenue that it likely will never collect from TBG as evidenced by numerous write-offs/reserves While RGS may have reduced some lease liability through the transaction, they have provided financial support and consideration in excess which they have conveniently added back to adjusted numbers, and still will likely be on the hook for lease payments.
Post the latest call, the most recent 8-K highlights further falloff in TBG operations with additional charge-offs for the current quarter (~$7.9MM). It also appears to us that TBG renegotiated lease terms with landlords for a small portion of stores (156), in which landlords have agreed not to go after RGS, while concessions from RGS/TBG are unknown per our understanding of the filing. The agreement also highlighted additional cash support from Regis for salons. Putting our “logic hats” on, we can conclude that these stores were likely the best performing of the TBG portfolio, in that the landlords clearly believed that providing rent concessions on these properties may lead to their survival. This small subset (~25%) of stores were the ones the landlords viewed as having a potential for survival and therefore warranted rent concession deals. This begs the question of just how bad the remaining  or so stores are and how much additional liability RGS may face as a result of supporting these stores.
We believe the TBG transaction was undertaken to artificially boost EBITDA by removing off balance-sheet an increasingly EBITDA negative segment with significant liabilities, pivot it into a revenue stream/profit generator which it appears that they will never collect yet conveniently write-off in later periods and concurrently adding them back to Adj. EBITDA when found uncollectable, boosting the metric for which Management’s cash incentive compensation is tied too. Given the degradation of the business and continued cash support costs, we believe TBG will either be consolidated back onto the balance sheet or RGS will be on the hook for liabilities from the asset. Either way, we believe at minimum it is prudent for management to not recognize TBG revenues in Adj. EBITDA and reverse prior addbacks.
The presentation of Regis’ financial transactions and relationships with TBG does not reflect the economic reality as TBG franchise payments benefit RGS’ income statement without the accompanying liabilities. Furthermore, we believe this is highly aggressive and does not match economic reality in the way Regis has dealt with the restructuring of TBG’s delinquent payments which are added back to adjusted results. This obscures the financial health of TBG and paints a picture which will leave shareholders holding the bag.
Red Flag #2: Reported Profitability Metrics Don’t Match Up with Economic Reality
Regis came onto our radar due to a massive divergence between free cash flow and the Company’s reported Adj. EBITDA number. Generally, a purportedly asset-lite business tends to convert EBITDA into free cash flow at high-rates driven by low CapEx, for Regis’ case CapEx has been roughly 2% of sales. We have rarely found “asset-lite” companies with growing Adj. EBITDA yet with negative free cash flow. Regis is one of the rare exceptions of companies that buck this trend. It is evident that this is due to overly aggressive accounting which does not reflect the true economic condition of the business.
We believe management has utilized an aggressive add-backs which amount to over 100% of mgmt. Adj. EBITDA. It is worth noting that management is paid based on adjusted EBITDA, providing management with significant incentive to aggressively implement “addbacks”. Below we provide a break-down of Adj. EBITDA and its components:
Source: Company filings, AR estimates
Note the $20.7MM addback for TBG. This was driven as RGS recognizing product sales/revenues over the past quarters yet realized they will never get paid for said sales, hence the charge-off. We believe it is misleading for RGS to recognize revenues/EBITDA that it will never collect from TBG in prior quarters, charge it off, only to add it back subsequently. We don’t believe investors should assess these revenues at face value as it highlights the cash support TBG requires to remain solvent despite their purported “sale” of the business to Regent. We believe operating Adj. EBITDA should back this charge out of adjustments.
A large portion of adjustments is derived from Regis’ gain on sale of salon assets to franchisees, net, This is where RGS effectively recognizes a one-time positive EBITDA contribution from selling stores at a low multiple of their underlying EBITDA, effectively chopping up the house to fuel the fire. This gain on sale item is broken into two components: “Gain on sale of venditions, excluding goodwill derecognition and a contra “Non-cash goodwill derecognition” which is netted against the amount.
While the net gain on sale flows through net income and is effectively a component of Adj. EBITDA, the negative goodwill charge is ALSO added back to adjusted numbers. Hence, only the purported benefits of the sale are wholly included in the Non-GAAP results. We believe this potentially violates regulatory guidelines.
We believe this potentially results in “tailored” accounting in violation rule 100 (b) of Regulation Gas (1) it appears that the adjustment only reflects part (only positive impact) but not all of the accounting concept from the gain on sale and (2) the adjustments do not reflect the underlying economics of the business as operating adj. EBITDA is down 45% year over year.
Given gain on sales are one-time in nature, it is more than prudent for one to remove the entire gross gain on sale from Adj. EBITDA in order to derive an “operating EBITDA” result. This is a superior metric to gauge results and we believe management is utilizing one-time gain on sales in order to artificially boost Adj. EBTIDA in order to achieve their requisite targets in order to obtain larger bonuses.
While Adj. EBITDA appears to have grown ~94% YoY per the last quarter, this was driven solely by gain on sales addbacks. In reality, operating EBITDA was down a staggering 45% year over year. See management’s commentary from 3/31/19 quarter below:
“Third quarter adjusted EBITDA of $37.2 million was $18.0 million, or 93.7% favorable versus the same period last year. Excluding the $27.4 million and $1.4 million gain from the sale of company-owned salons during the current and prior year quarter, respectively, adjusted EBITDA of $9.7 million was $8.0 million, or 45.2% unfavorable versus the same period last year driven primarily by the elimination of EBITDA that had been generated in the prior year period from the 635 company-owned salons that were profitably sold and converted to the Company’s asset-light franchise portfolio over the past 12 months.”
Management was asked about the poor cash conversion on the January 2019 earnings call. Not only did the CEO not know what cash conversion was, they could not provide what we believe should have been a concise response on what we feel is a relatively straight forward topic, they resorted to the “let’s take this off-line” answer. See below:
Rory A. Held
Okay, we'll look forward to the disclosure. In terms of one other comparison to the quick-service franchise model. So franchise is now like 53%, 54% of the total business, yet cash from operations is -- there's a significant variance between cash from operations and adjusted EBITDA. And so can you explain what holds back cash conversion? Because in a franchise model, it should be pretty tight.
Hugh E. Sawyer
Can you define what you mean by cash conversion?
Rory A. Held
Sure. So if we look at the first 6 months, you've done negative $10 million of cash from operations but $45 million of adjusted EBITDA. And so there's a $55 million delta between what you're sort of reporting as adjusted EBITDA and what's actually been cash collected. And when you look at any quick-service restaurant, there is a much, much tighter correlation there and they never really go negative cash from operations, so just curious.
Andrew H. Lacko
So Rory, why don't we take this off-line because we can walk you through the puts and takes. There is a number of moving parts that -- as we continue this transition [indiscernible] you through to kind of walk you through the cash conversion.
Hugh E. Sawyer
And it's not -- it may not be directly comparable and likely isn't to quick serve. I think Andrew's quick serve comment was merely indicated to illustrate that we're not the first company that's gone down the path of thinking about converting operating locations to franchise.
Andrew H. Lacko
Especially as we are midway through the transition process.
Hugh E. Sawyer
Right. Or maybe...
Rory A. Held
But the franchise business should be -- I mean, it should be 1 month or whatever of receivable are not even, right? It should be pretty tight. So the cash conversion should be high. Is that a correct assumption?
Andrew H. Lacko
It is pretty tight, but as we continue to build out the muscle of the franchise group, as it's becoming a significant portion of portfolio, there are investments that we need to make in order to facilitate the transactions because a number of transactions that we're putting through the pipe, while temporary, require additional resources. So the conversion might be a little lower in the transition phase than what we ultimately would expect once we get to the other side of the river in a more steady state portfolio mix.
Hugh E. Sawyer
But I think in an off-line call, we can get you there, Rory. We'll help you get there.
Source: Regis 2Q19 Earnings Call
Red Flag #3: Underlying Fundamentals Strongly Suggest Regis’ Brands are in Secular Decline
Abysmal Same Store Sales
Regis’ brands have exhibited over 15 quarters and over 3 years of negative traffic. This is not sustainable and has continued despite hundreds of store closures (almost 20% of the system) over the past four years. While RGS does not provide traffic/ticket breakdown for franchisees (SSS has still negative per the last Q), they do provide it for their company owned stores which paints a dim picture:
Source: Company Filings Internal Calcs/Charts
Per the traffic data provide above, it is clearly evident Management’s plans such as closing underperforming stores has not improved the fundamental prospects.
RGS’ has seen its store count shrink from 9,763 as of FY13 to 7,138 as of 3/31/19. When viewed in conjunction with the traffic declines, it is evident that Regis’ underlying brands are losing market share to a combination of new regional brands and a plethora of mom and pops. Moreover, RGS is heavily exposed to labor trends which are moving upwards.
Poor Franchisee Economics
RGS franchisee base is not highly profitable as evidenced within the FDD as Franchisee average unit volumes and profitability are abysmal. Considering RGS is first likely selling their worst properties, franchisee profitability metrics (not disclosed) are likely meaningfully below Company owned stores reported in the FDD.
From the October 29th2018 FDD for SuperCuts:
Per the above charts, ~2/3s of SuperCuts stores would earn ~$8K to $38K in operating cash flow or 4% to ~13% EBITDA margins when including the increased product costs. This is too low of profitability to make it a worthwhile investment when considering time, etc. Moreover, we believe corp. owned stores tend to have better profitability/locations vis-à-vis franchised stores.
The estimated initial investment for a salon per the FDD is ~$151K to $321K. Using a mid-point of $236K, the payback for Group B and C (~66% of the group) ranges from 29.5 to 6.2 years.
See below for the breakdown of the SmartStyle (Wal-Mart stores) October 30th 2018 FDD, yet note they exclude ~379 recently franchised stores:
It’s clearly evident this segment lacks scale as average unit volumes for the top third only generating ~$348K in avg revenue and ~$45K in operating cash flow. The remaining 2/3s generated a meager $16K of operating cash flow at best, with the bottom third losing $5K per store. Hence, it’s not surprising seeing stores in this segment shrink by ~585 units.
Source for SmartStyle FDD: https://www.wdfi.org/apps/FranchiseSearch/details.aspx?id=620228&hash=840298291&search=external&type=GENERAL
Potential and current Regis investors should pay much attention to the competitive landscape as peers such as Great Clips and Sports Clips continue to make inroads. Great Clips for instance has invested in their technology platform, opened new salons (~850 or ~4,371 at the end of 2018) more importantly has experienced ~56 quarters of salon sales growth versus Regis which continues to experience negative SSS. According to IBISWorld the hair salon industry is expected to grow 1.5% in FY19 and has grown ~2.1% over the past five years. Hence, it’s easy to conclude that RGS has lost market share.
Similar to the restaurant and retailing industries particularly as labor is becoming an increasing headwind. It is common knowledge that minimum wages are increasing across multiple states, with California being the worst. RGS calls this out in their filings as a potential headwind:
There is also a low unemployment rate and high competition for employees in the service industry, particularly licensed employees, which drives increased competition for stylists and could result in retention and hiring difficulties. In some markets, we and our franchisees have experienced a shortage of qualified stylists. Offering competitive wages, benefits, education and training programs are important elements to attracting and retaining qualified stylists. In addition, due to challenges facing the for-profit education industry, cosmetology schools, including our joint venture EEG, have experienced declines in enrollment, revenues and profitability in recent years. If the cosmetology school industry sustains further declines in enrollment or some schools close entirely, or if stylists leave the beauty industry, we expect that we and our franchisees would have increased difficulty staffing our salons in some markets. If our company-owned salons or franchisees are not successful in attracting, training and retaining stylists or in staffing our salons, our same-store sales or the performance of our franchise business could experience periods of variability or sales could decline and our results of operations could be adversely affected.
We believe street estimates calling for ~$76MM of Adj. EBITDA for FY20E are simply too high. Given the latest 45% drop YoY in Adj. operating EBITDA to ~$9MM per quarter (inclusive of the TBG addback), Regis will be hard pressed to generate more than $55MM of operating EBITDA per annum.
Secondly, it is evident that Regis’ largest franchisee TBG, is on the verge of collapse likely leading to further charge-offs beyond the $20.7MM last quarter. Furthermore, we believe RGS may have negative accounting events related to liabilities for this entity as hinted in the risk factors on top of potential issues stemming from aggressive addbacks etc.
Regis currently trades at a very rich multiple at ~15.5x EBITDA and a negative FCF yield for an asset that derives a majority of its EBITDA from company-owned salons. Furthermore, Regis has been selling off profitable salons to franchisees at anywhere from 2x to 4x EBITDA. Assuming an 7x multiple on our operating EBITDA (ex. gain on sales) of ~$45MM, we come out with a $9 per share target. We believe is more than generous considering the structural issues with traffic and potential accounting issues listed above.
Author may buy or sell additional shares or all of these shares at any time. Author has no obligation to inform anyone of any changes to Author’s view of RGS or any ticker noted above. The information set forth in this article does not constitute a recommendation to buy or sell any security. This article represents the opinion of the author as of the date of this article. Please consult your financial, legal, and/or tax advisors before making any investment decisions. This article contains certain "forward-looking statements," which may be identified by the use of such words as "believe," "expect," "anticipate," "should," "planned," "estimated," "potential," "outlook," "forecast," "plan" and other similar terms. While the Author has tried to present facts it believes are accurate, the Author makes no representation as to the accuracy or completeness of any information contained in this note.
To the best of our ability and belief, all information contained herein is accurate and reliable, and has been obtained from public sources we believe to be accurate and reliable, and who are not insiders or connected persons of the stock covered herein or who may otherwise owe any fiduciary duty or duty of confidentiality to the issuer. We have a good-faith belief in everything we write; however, all such information is presented "as is," without warranty of any kind – whether express or implied.
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