Description

RGS is a beaten-down company that was hit hard by COVID.  This business has bottomed out and is on the path to recovery with significant upside potential for the stock. Performance undermined by elevated exposure to COVID, the substantial deterioration in stock price, earnings and cash flow has masked the fact that RGS has wrapped up a major business model transition.  Now, RGS represents an opportunity to own a recession-proof, asset-light business that is generating 30%+ EBITDA margins at a significant discount to fair value.  We think the business is worth $7, representing a 6x return.  

Company Overview 

Regis is a hair salon franchisor with over 5,000 salons in the United States. Supercuts is the most well-recognized brand in the Regis portfolio, but through a multi-year roll-up strategy pursued by the founding CEO, they have historically operated over 40 other brands. Five years ago, 50% of the salon fleet was owned and operated by the company, and the other 50% was operated by a network of almost 600 franchisees. Over the past four years, Regis has sold off most of its company-owned stores to franchisees and has consolidated its long tail of brands into one of 5 major banners - Supercuts, Smart Style in Wal-Mart, and its Portfolio Brands comprised of Cost Cutters, Roosters and First Choice Hair Cutters.

Refranchising Strategy  

Starting in 2018, RGS embarked on a refranchising strategy transitioning its company-owned salons to franchise-owned salons. This strategy made sense because franchised salons generally produce ~10-20% more revenue than those that are company-owned, and the pure franchisor model is asset-light and generates higher FCF.  Regis’s two largest competitors, Great Clips and Sport Clips, operate as full franchise business models and are highly successful so there was clear precedent for pursuing this strategy.

Franchising is a well understood way to increase shareholder value. The trend is predictable - during the transition, revenue, EBITDA and cash flow decline as the company can only reduce corporate store infrastructure after a certain threshold of stores have been sold. After this period, EBITDA improves, and EBITDA margins and cash flow inflect. Typically, multiples inflect as well. The QSR industry has seen several successful franchising reorganizations.  Major QSRs such as MCD, WEN, YUM and JACK have all refranchised a large chunk of their stores.

There is no other way of saying it; Regis' transition has been a horrible one. No franchising transition that we know of has gone through this kind of restructuring in as short of a timeframe as RGS has, so the impact to EBITDA has been much more pronounced. Furthermore, COVID hit RGS right at this particularly vulnerable time. Hair salons have been arguably one of the hardest hit industries throughout COVID given the need for social distancing and fewer haircuts due to remote work. Pre-COVID results were roughly in line with the predicted trend, but things went off the rails throughout COVID when salons were either closed completely or traffic declined by 50-70%. On top of an inflated cost basis these shutdowns really hurt the business. As a result, Regis has burned cash for the last 12 quarters and the optics are extremely ugly.

Note: the fiscal year end is in June.

Thankfully, RGS completed the transition to franchisor, and currently has only 75 corporate-owned salons left in the fleet of which they have line of sight to wind down 60 in the next 12 months.  As detailed below, there is light at the end of the tunnel as costs related to operating the corporate-owned stores have been eliminated and cash generation should return in the next 6-12 months.

RGS and COVID.  Wrong place, wrong time.

Regis has three main brands, all of which operate at different 4-wall revenue and profit levels. Before the pandemic, an average Supercuts salon earned around $290,000 in revenue yearly and an estimated $42,500 in profit per store, or a 14.5% operating margin. Throughout the pandemic, we estimate that 4-wall revenue bottomed at down 70-80% vs. 2019 baseline pre-pandemic levels, and today is roughly flat to up low single digits to the 2019 baseline. Cost Cutters (the largest brand in the Portfolio Brand segment) is about in line with Supercuts and the Smart Style Wal-Mart salons are worse off.

Franchisees are using a lot of tools to improve their results. They are experimenting with pre-check-in and are using analytics to optimize staffing during busy hours. Prices have increased ~20% across the board at Regis salons and their competitors.  Franchisees have shored up balance sheets with PP1, PP2 and ERTC funding in addition to low interest rate debt. Based on extensive conversations with franchisees, most salon owners are operating at a profit and balance sheets have never been stronger.  Their biggest problem without question is a labor (stylist) shortage that is forcing many franchisees to curtail hours or to close one day a week when they would otherwise be open. Universally we have been told by salon owners that if labor were not an issue, Supercuts franchisees would be well above pre-pandemic revenue given strong demand combined with higher prices.

While the past three years have been extremely difficult for many franchisees trying to survive the rollercoaster of shutdowns and capacity restrictions, overall, many franchisees are in a relatively strong place with plenty of cash in the bank and are operating at a profit / positive cash flow.

Now for RGS corporate (the franchisor) the picture isn't as rosy. The story is simple although until recently the company has done a poor job of communicating it.  While salons were closed in the depths of 2020, Regis drew on their revolver which significantly increased their debt load from $90mn to ~$180mn.  In mid-2021, their largest shareholder and Chairman of the Board dumped his 30% ownership on the open market and subsequently resigned from the board.  In late 2021, they tapped $37mn of their outstanding $50mn ATM which increased their share count from 36mn to 46mn shares.  At this time, the company was burning cash and the March 2023 debt maturity loomed in a tough financing market.  To exacerbate the issue, Felipe Athayde, the CEO who was put in place in October 2020 to navigate the company out of COVID and towards growth, resigned in December 2021 for “personal matters”.  Any confidence in the liquidity picture was squashed.  

Turning a Corner

Matt Doctor was named interim CEO upon Felipe’s departure and to his credit, Regis turned a corner in 2022.  In June 2022, they sold OSP, their internally developed POS system, to Zenoti for $39mn. OSP was a drag on cash flow and a distraction to management. In August 2022, they successfully renegotiated their debt for an August 2025 maturity at a reasonable cash rate of SOFR+4.25%.  They have successfully reduced SG&A from ~$120mn in 2019 to ~$55mn a year to better align with the franchisor model. They also brought in a third-party distributor to manage all salon retail sales. 

Both the business model transition and liquidity profile improvement have gone unnoticed by the street.  RGS has been stuck in the doldrums with little investor interest for the past year.  For a few reasons, we think that is about to change:

1.       Profitability. Now that the money losing corporate salons are behind them and the cost base has been right sized, RGS’ true profitability is starting to materialize.  RGS has generated positive total EBITDA for the last two quarters at an annualized rate of ~$25mn and a margin in the 30% range. 

2.       Debt Paydown from Zenoti Earn Out. They will receive $22mn in cash from Zenoti as their salons move over to the Zenoti platform in the next 12 months as part of an earn out.  This cash will further reduce their net debt at which point leverage should be around 5.5x, which is in line with peers in the 5-7x range.

3.       Cash Flow. RGS is about cash flow breakeven with line of sight to cash generation in the next 12 months as working capital from the remaining corporate-owned salon product sales is run off, profitability improves, and they pay down debt with the Zenoti earn out.  We estimate RGS will generate ~$20mn of cash in 2025 with a 30%+ levered FCF yield at today’s valuation.  Today the company has $48mn in total liquidity through cash and a revolver.  

4.       Debt Paydown from Cash Flow.  Excess cash flow will go towards further paying down debt.  By 2025, leverage should easily be less than ~3.5x. 

5.       Labor. Many salons today are still operating under abbreviated hours.  Franchisees report that demand is there but they don’t have feet on the ground.  As stylists come back to work, salons can resume normal business hours driving further upside to revenue.  While RGS is not pandemic proof, it does do well in a recession as both customers move down the value spectrum and stylists, who often leave the industry in the go-go years for other jobs, move back into hair styling during a recession. 

6.       Salon Growth. Throughout the pandemic, franchisees and RGS corporate collectively closed about 30% of the fleet, split about evenly between franchisees and RGS corporate.  Of the salons closed, 30% were corporate-owned closures part of a pre-COVID plan. We view this as a good pruning exercise, leaving a stronger fleet of salons and room to reestablish salons at better locations (sometimes a location just across the street in a better strip mall can have significantly better results) and at more advantageous rent rates in the mid to long term.

7.       Sell-side coverage. Management is working hard to get a sell-side analyst to pick up coverage.  On the last earnings call, we noticed a Jefferies analyst asked a question in addition to an analyst from Small Cap Consumer Research.

8.       Conferences. Management is working hard to get the word out there.  RGS participated in the Wolfe Conference in December 2022 and ICR in January 2023 (webcast available online). 

9.       External IR. Management is working on hiring an external IR.

10.   Operating Leases.  Operating leases will roll off the balance sheet and income statement over the next three to five years as franchisees renegotiate leases. This significantly improves the screened leverage levels and reduces the pass-through complexity on the income statement.

This company does not screen well for a variety of reasons.  First, RGS looks massively levered on a screen due to the long-term operating lease balance of $446mn which generally shows up as debt. However, 95% of these leases are held in the franchisee’s name with the franchisee holding a personal guarantee, backed by RGS. This is not standard practice in the salon franchising world but something RGS did under the original regime. Leases were an off-balance sheet liability until recently when accounting standards changed. These leases will slowly roll off their balance sheet as they are renewed, and this balance will decline over the next 3-5 years. Operating leases related to the remaining company-owned salons and corporate leases are $13mn. We view the risk that leases act as RGS’ debt as relatively low given their historical experience of having nearly no franchisee defaults for which RGS was liable even through 2020.

Second, RGS’ reported revenue includes an advertising fund pass-through and a franchise rent pass-through which artificially inflate revenue and deflate margins.  The ad fund pass through is routinely excluded from revenue in the calculation of EBITDA margin with franchisors so we also exclude it. The franchise rent pass through is the result of recent accounting changes where RGS includes franchisee lease liabilities on their balance sheet and books franchise rent as revenue.  This is a 1:1 pass through, and we also exclude it from revenue in the calculation of EBITDA margin.

Valuation

While the financials are extremely messy, the business model is that of a straightforward franchisor.  RGS earns a percent of their franchisee revenue in the form of a royalty and advertising fee, and they earn other fees from product sales commissions, an annual training fee, and a new salon fee.  They have a fixed SG&A base and moderate rent on their headquarters.  Embedded in their SG&A is a ~$3mn amortization fee not included in D&A related to broker fees that they paid to find new franchisees back in 2018 and 2019.  They no longer pay brokers, and this expense is non-cash, so we back it out. 

Our expected case assumes RGS will earn ~$45mn in EBITDA by 2025 based on moderate improvement in volume and rolling price increases by franchisees.  After RGS is through this stabilization, we expect them to refocus on store growth where they can earn ~$60mn in EBITDA reflecting our bull case. 

Today, RGS is trading at 8.5x on 2023FY (ended 06/2023) EBITDA. We assume a 9.5x multiple on a 2025FY EBITDA of $45mn which implies a $7 stock price or a 6x upside to today’s price of ~$1.20.  We think this is conservative as their health and wellness franchisor comps, EWCZ, PLNT and XPOF, trade for 22-30x EV/EBITDA.  Additionally, QSR franchisor comps with similar margins and leverage ratios trade for 16-21x EV/EBITDA.  As their profitability and growth outlook improves, we can justify a higher multiple in the mid-teens range and can easily see a stock price approaching the high-teens.

Risks

• Labor availability doesn’t improve

• SG&A Cost Control – CEO Matt Doctor comes from Restaurant Brands International (ticker: QSR) where the 3G zero based budgeting (ZBB) philosophy was gospel. Maintaining cost control will require management execution.  So far, they have exceeded expectations.

• Continued conflict between the franchisee base and senior management – It is worth noting that the transition to franchisor has strained the franchisor/franchisee relationship. The previous CEO alienated the franchisees by pushing major strategy changes without soliciting feedback.  Matt Doctor and his team have implemented a number of no-brainer policies such as adding regular franchisor/franchisee check-in video calls, bringing back in person education for stylists, and rewarding top performers at an annual conference in Las Vegas. Optimism within the franchisee group has dramatically improved from all-time lows a year ago.   

Catalyst

·         Profitability Improves

·         Debt Paydown from Zenoti Earn Out

·         Debt Paydown from Cash Flow

·         Cash Flow Generation

·         Labor Improves

·         Salon Growth

·         Sell-side coverage

·         Conferences

·         External IR