Wednesday, September 26, 2007

"Gimme Head with Hair, " Says Regis Corp.

As the industry's global leader in salons and hair restoration centers, beauty means business at Regis Corporation (RGS-$30.73). The owner of such recognized salon franchise concepts as Vidal Sassoon, Supercuts, and SmartStyle (U.S.) and First Choice Haircutters (in Canada) and Hair Club for Men and Women (North America) projects sales to hit $2.7 billion in fiscal year ended June 30, 2008, from $1.9 billion in FY 04.

Financial Guidance

Management has grown revenue at a 5-year historic growth of 12.55% by building a portfolio of 11,881 salons through acquisition, new construction and franchising.

Increases in average ticket prices offset by continued declines in visitation patterns due to fashion trends (i.e., longer hairstyles) resulted in consolidated same-store sales growth of only 0.2 percent, 0.4 percent, and 0.9 percent in fiscal 2007, FY 06, and FY 05, respectively. Management expects fiscal year 2008 same-store sales growth to be consistent with this trend toward flat to 1.0% same-store sales growth.

The Company reported that earnings fell 24 percent to $83.2 million, or $1.82 per share, in 2007, compared to $109.6 million, or $2.36 per share, during 2006, due to higher operating expenses (as a percentage of sales) and impairment charges. Management blamed higher general & administrative costs on lower than normal salon advertising expenses in fiscal 2006 and negative leverage associated with minimum rents, area maintenance charges, and real estate taxes (growing at a rate slightly higher than same store sales).

Citing the aforementioned trends, the company, which also owns Jean Louis David and the Regis brand salons, recently reduced net income guidance for 2008 to the range of $2.01 to $2.27 per share. Analysts expected share-net of $2.25 in 2008, according to a Thomson Financial survey.

Opportunistic acquisition activity boosted sales 4.4% (year-year), respectively, but so, too, financial leverage. Interest expenses increased 30 basis points (as a percentage of sales) in the last 12-months.

Debt-to-capitalization level increased 200 basis points to 43.7%, primarily due to increased debt levels stemming from share repurchases, acquisitions and timing of customary income tax payments made during fiscal year 2007.

One balance sheet warning—the Company owes $875 million in off-balance sheet obligations (principally operating leases)—due within three years—that if added, would more than double the debt-capitalization ratio to 1.06 times.

The interest coverage ratio, however, is a comfortable 3.3 times earnings (before interest and taxes) and cash flow from operating activities was $241.8 million for FY 07.

Business Outlook

It is foolish to tear one's hair in grief, as though sorrow would be made less by baldness. ~ Roman Statesman and Philosopher Marcus Cicero [106 BC – 43 BC]

Tell that to Regis shareholders. Low organic growth and reduced earnings visibility has shaken investor confidence, with the share price down 14.85% (53-week change) compared to a 13.63% gain in the S&P 500 Index.

Life is an endless struggle full of frustrations and challenges, but eventually you find a hair stylist you like. ~Author Unknown

Management reminded investors on its fourth quarter conference call that demographics favor the Company’s business strategy. “As the population ages, said CEO Paul Finkelstein, “Individuals have to get their hair cut and colored more often. We are primarily a service-driven business… Once we get people going into our salons…we have a better opportunity to convert these customers to become retail product purchasers as well.”

The 10Q Detective points out several weaknesses in Finkelsteins’ argument: (i) Management has—to date—poorly executed on converting existing traffic into an add-on revenue stream. To wit: product sales fell 100 basis points, to 28.6% of consolidated sales, from 29.6% in fiscal 2005 (management blames increasing sales of diverted product lines and greater retail competition—e.g. Victoria’s Secret morphing into a beauty store); and (ii) although centralized control over salon operations have yielded some economies of scale (with gross margin as a percentage of service and product revenues improving 60 basis points in the last two years), traffic patterns remain soft (falling 3.5% in 2007).

The 10Q Detective does not expect a turnaround in product sales until at least the 1H:09. Regis management is looking to convert its 62,000 hair stylists into retailers. (We are not as optimistic as management about this opportunity, for more sales training means higher labor costs—unspecified, too, was employee turnover numbers and compensation incentives for cross-selling.)

Investment Thesis

By fiscal 2009, the Company expects successes in reducing diversion programs from Proctor & Gamble and L’Oreal and will be readying new product launches.

Regis is designing a customer loyalty program to work in some of its strip centers and its Master Cuts division (we are not as bullish as management on loyalty programs, for SuperCuts has one program already in place—nine haircuts, tenth free).

In our view, the Hair Club represents a forward growth driver. Fourth quarter revenue for fiscal 2007 increased about 11%, to $31.9 million, which was $2.5 million above plan. Hair Club revenues represented nearly 5 percent of consolidated 4Q:07 revenues. Strangely, aside from some talk about buying back franchises (increased margins) and “buying customer lists,” management was vague on how it planned to grow this segment (which sprouted a fourth quarter operating margin rate of 21.3%--or 130 basis point improvement year-year).

In the face of sliding performance metrics—trailing twelve month ROA and ROE of 4.0% and 9.3%, respectively, compared with five-year ROA and ROE averages of 6.28% and 13.2%, respectively—we are ‘less-than-comfortable’ with management’s ability to execute on its stated initiatives, too.

With Regis expected to generate only modest growth in the coming quarters, coupled with concerns about consumer discretionary spending (rising food and energy costs), we do not believe that any catalysts exist for a sustainable upward move in the stock price at this time.

Long-term investors with an eye toward value, however, may want to establish a forward position in the stock, with the stock selling at a modest 12.8 times June ’09 estimates of $2.43 per share. Intrinsic stock value is estimated at $46.50 per share.

Gimme head with hair
Long beautiful hair
Shining, gleaming,
Streaming, flaxen, waxen

In our view, however, such optimism is premature, for forward valuation assumes weighted average cost of capital of 6.8% and sustainable top-line growth of 8 percent (per annum). Sales move inversely to hair cut lengths—contrary to management’s stated opinion—there is little evidence to support shorter hairstyles are coming back in vogue.

Give me down to there hair
Shoulder length or longer hair
Here baby, there mama
Everywhere daddy daddy

Hair, hair, hair, hair
Grow it, show it
Long as I can grow it
My hair

The faces of management at Regis must blanche in terror upon hearing such lyrics [from the bubblegum, psycho-pop group The Cowsills].

Beauty may mean business at Regis, but a look at related party transactions reveals that only insiders consistently profit from the haircuts, styling, coloring and waxing services provided to
“more than 160 million satisfied clients each year.”

Certain Relationships and Related Transactions

Mr. Myron Kunin, 78, is a founder of Regis and has served as a director since its incorporation in 1954. He is Vice Chairman of the Board (earning a salary of $789,371 in FY 07) and holds the majority of voting shares of Curtis Squire, Inc. (CSI), a significant shareholder of Regis, the beneficial owner of 1.02 million shares, or 2.31% of the outstanding common stock).

Curtis Squire, Inc rents artworks to the Company in return for which Regis compensates certain of its employees who devote time to CSI business. Regis also furnishes office space and equipment for use by CSI. The reasonable value of this arrangement was estimated at $200,000 last year.

Messer. Kunin received $134,851 in annual pension benefits in 2007. The present value of accumulated benefits is $7.08 million, for 53 years of credited service [god bless him!]. Kunin did not take any non-qualified deferred compensation in 2007, leaving his plan with an aggregate value of $2.22 million.

The Company paid $1,268,396 to Beautopia, LLC, which is owned by David B Kunin and CSI, for hair care products purchased in the ordinary course of business in 2007. In addition, Mr. Kunin serves as a director at Regis, receiving total compensation of $74,506 in 2007. David Kunin, 48, is the son of Myron Kunin.

Regis paid Timothy Kunin, a son of Myron Kunin and a brother of David Kunin, $309,938 for subscriptions to magazines for the salons in 2007.

The Company purchases from the Northwestern Mutual Life Insurance Company insurance policies on the lives of certain of its employees and officers. Regis paid aggregate premiums of $3,432,286 for these insurance policies in 2007.

Michael Finkelstein, a son of Paul Finkelstein, is a registered insurance agent and received commissions of $404,479 related to these insurance policies in 2007!

The Company reimburses Chairman and CEO Paul Finkelstein $100,000 annually for premiums payable by the Executive with respect to life insurance coverage under a policy with a face amount of $10 million. Regis also provides Mr. Finkelstein with a gross-up for the federal and state income taxes on the resulting income.

By comparison, Microsoft just announced that it gave CEO Steve Ballmer approximately $3,000 worth of life insurance premiums in the last year!

Editor David J. Phillips does not hold a financial interest in Regis Corp. The 10Q Detective has a Full Disclosure Policy.

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