UNITED STATESSECURITIES AND EXCHANGE COMMISSION
FORM 10-Q
(Mark One)
For the quarterly period ended March 31, 2005
OR
For the transition period from____________________ to___________________
Commission file number011230
Regis Corporation
(952)947-7777
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes þ No o
Indicate the number of shares outstanding of each of the issuer’s classes of common stock as of April 30, 2005:
REGIS CORPORATION
INDEX
PART I — FINANCIAL INFORMATION
The accompanying notes are an integral part of the unaudited Condensed Consolidated Financial Statements.
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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (cont.)(Unaudited)
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For the Three Months Ended, March 31,
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REVIEW REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Shareholders and Directors of Regis Corporation:
We have reviewed the accompanying condensed consolidated balance sheet of Regis Corporation as of March 31, 2005 and the related condensed consolidated statements of operations for the three and nine month periods ended March 31, 2005 and 2004 and of cash flows for the nine month periods ended March 31, 2005 and 2004. These interim financial statements are the responsibility of the Company’s management.
We conducted our reviews in accordance with the standards of the Public Company Accounting Oversight Board (United States). A review of interim financial information consists principally of applying analytical procedures to financial data and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with the standards of the Public Company Accounting Oversight Board (United States), the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion.
Based on our reviews, we are not aware of any material modifications that should be made to the accompanying condensed consolidated interim financial statements for them to be in conformity with accounting principles generally accepted in the United States of America.
We previously audited in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet as of June 30, 2004, and the related consolidated statements of operations, of changes in shareholders’ equity and comprehensive income and of cash flows for the year then ended (not presented herein), and in our report dated August 24, 2004, except for Note 2, as to which the date is May 9, 2005, which contained explanatory paragraphs indicating (i) the Company changed its method of accounting for equity-based compensation arrangements to begin expensing new awards as of July 1, 2003 and (ii) the company restated its financial statements as of June 30, 2004 and 2003 and for the three years then ended to account for rent holidays on a straight-line basis, we expressed an unqualified opinion on those consolidated financial statements. In our opinion, the accompanying consolidated balance sheet information as of June 30, 2004, is fairly stated, in all material respects in relation to the consolidated balance sheet from which it has been derived.
As discussed in Note 2 to the accompanying condensed consolidated interim financial statements, the company restated its prior year financial statements for the three and nine month periods ended March 31, 2004.
/s/ PricewaterhouseCoopers LLP
PRICEWATERHOUSECOOPERS LLP
Minneapolis, MinnesotaMay 9, 2005
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RESTATEMENT OF FINANCIAL STATEMENTS
During our current fiscal quarter ending March 31, 2005, we became aware that a number of retailers and restaurant operators had disclosed in their filings with the SEC that they were reassessing their accounting related to leases and that some companies had restated their financial statements to reflect changes in their accounting for leases. In light of these disclosures and restatements, we conducted a review of our lease accounting policies and practices.
In our lease accounting review, we examined our leases to determine the appropriate lease term for each lease under GAAP. Typically, our operating leases do not require rental payments to begin until the salon is opened. The leased space is sometimes made available to us prior to the commencement of salon operations in order to allow time for installing normal leasehold improvements and equipment necessary to operate a salon. We historically began to recognize rental expense on a straight-line basis at the earlier of the commencement of operations or the commencement of rental payments. However, we did not include the rent holiday period in our straight-line rent calculation. A rent holiday is considered to be any period where the lessee has the right to control the use of the leased property but no rental payments are required under the lease during that period. FASB Technical Bulletin (FTB) 85-3, “Accounting for Operating Leases with Scheduled Rent Increases,” requires rent holiday periods in an operating lease to be recognized by the lessee on a straight-line basis over the lease term, which includes any rent holiday period. Therefore, we are restating our financial statements for fiscal years 2004, 2003 and 2002 to appropriately account for rent holiday periods. The restatement to appropriately account for rent holidays had no impact on our consolidated revenues or cash flows from operations.
Based on the review of our accounting for operating leases, we have restated our previously issued financial statements in our Annual Report on Form 10-K for the fiscal year ended June 30, 2004, and will restate those in our Quarterly Reports on Form 10-Q for the quarters ended September 30, 2004 and December 31, 2004 as soon as reasonably practicable. We filed a Form 10-K/A with restated Consolidated Financial Statements, and will file a Form 10-Q/A for each of these interim reporting periods with restated Condensed Consolidated Financial Information.
See Note 2 to the Condensed Consolidated Financial Statements for a summary of the effect of this change on our Condensed Consolidated Balance Sheet as of June 30, 2004 and the Condensed Consolidated Statement of Operations for the three and nine month periods ended March 31, 2004.
MANAGEMENT’S OVERVIEW
Regis Corporation (RGS) is the beauty industry’s global leader in beauty salons, hair restoration centers and education. As of March 31, 2005, our worldwide operations included 10,698 system-wide North American and international salons, 90 hair restoration centers and 19 beauty schools. Each of our salon concepts offer generally similar products and services and serves mass-market consumers. Our salon operations are organized to be managed based on geographical location. Our North American salon operations include 8,688 salons, including 2,291 franchise salons, operating in the United States, Canada and Puerto Rico primarily under the trade names of Regis Salons, MasterCuts, Trade Secret, SmartStyle, Supercuts and Cost Cutters. Our international salon operations include 2,010 salons, including 1,589 franchise salons, located throughout Europe, primarily in the United Kingdom, France, Italy and Spain. In December 2004, we purchased Hair Club for Men and Women. This enterprise includes 90 North American locations, including 41 corporate and 49 franchise locations. Our beauty schools are managed in aggregate, regardless of geographical location, and include 15 locations in the United States and four locations in the United Kingdom. During the third quarter of fiscal year 2005, we had an average of approximately 52,000 corporate employees worldwide.
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Our growth strategy consists of two primary, but flexible, building blocks. Through a combination of organic and acquisition growth, we seek to achieve our long-term objective of 10-to-14 percent annual revenue growth. We anticipate that going forward, the mix of organic and acquisition growth will be roughly equal. However, depending on several factors, including the ability of our salon development program to keep pace with the availability of real estate for new construction, student enrollment, hair restoration lead generation, the availability of attractive acquisition candidates and same-store sales trends, this mix will vary from year-to-year. We believe achieving revenue growth of 10-to-14 percent, including same-store sales increases in excess of two percent, will allow us to increase annual earnings at a low-to-mid teen percent growth rate. We anticipate expanding our presence in both North America and Europe. Additionally, we desire to enter the Asian market within the next five years.
Maintaining financial flexibility is a key element in continuing our successful growth. With strong operating cash flow and an investment grade credit rating, we are confident that we will be able to financially support our long-term growth objectives.
Salon BusinessThe strength of our salon business is in the fundamental similarity and broad appeal of our salon concepts that allow flexibility and multiple salon concept placements in shopping centers and neighborhoods. Each concept generally targets the middle market customer, however each attracts a different demographic. We anticipate expanding all of our salon concepts. In addition, we anticipate testing and developing new salon concepts to complement our existing concepts.
We execute our salon growth strategy by focusing on real estate. Our salon real estate strategy is to add new units in convenient locations with good visibility, strong customer traffic and appropriate trade demographics. Our various salon and product concepts operate in a wide range of retailing environments, including regional shopping malls, strip centers and Wal-Mart Supercenters. We believe that the availability of real estate will augment our ability to achieve the aforementioned long-term growth objectives. We anticipate that we will add approximately 1,000 net salons each year through a combination of organic, acquisition and franchise growth.
Organic salon revenue growth is achieved through the combination of new salon construction and salon same-store sales increases. Each fiscal year, we anticipate building several hundred corporate salons. We anticipate our franchisees will open several hundred salons as well. Older, unprofitable salons will be closed or relocated. Our long-term outlook for our salon business is for annual consolidated low single-digit same-store sales increases. Based on current fashion and economic cycles, we project our annual fiscal year 2005 consolidated same-store sales increase to be below the low end of our long-term outlook range.
Historically, our salon acquisitions have varied in size from as small as one salon to over one-thousand salons. The median acquisition size is approximately ten salons. From fiscal year 1994 to fiscal year 2004, we completed over 300 acquisitions, adding a net of approximately 7,000 salons. We anticipate adding several hundred corporate salons each year from acquisitions. Some of these acquisitions may include buying salons from our franchisees.
Hair Restoration Business
In December 2004, we acquired Hair Club for Men and Women. Hair Club for Men and Women is the industry leading provider of hair loss solutions with an estimated four to five percent share of the $4.3 billion domestic market. This industry is comprised of approximately 4,000 locations domestically and is highly fragmented. As a result, we believe there is an opportunity to consolidate this industry through acquisition. Expanding the hair loss business organically and through acquisition would allow us to add incremental revenue which is neither dependent upon nor dilutive to our existing salon and school businesses.
Our organic growth plans for hair restoration include the construction of a modest number of new locations in untapped markets domestically and internationally. However, the success of our hair restoration business is not dependent on the same real estate criteria used for salon expansion. In an effort to provide confidentiality for their customers, hair restoration centers operate primarily in professional or medical office buildings. Further, the hair restoration business is more marketing intensive. As a result, organic growth at our hair restoration centers will be dependent on successfully generating new leads and converting them into hair restoration customers. Our growth expectations for our hair restoration business are not dependent on referral business from, or cross-marketing with, our hair salon business, but will be evaluated closely for additional growth opportunities.
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Beauty School Business
We have begun acquiring and are exploring the possibility of building beauty schools. The beauty school business is highly profitable, and often participates in governmental programs designed to encourage education. We believe there is an opportunity to place graduates in our various salon concepts which may provide us with another competitive advantage. Similar to the salon and hair loss industries, the beauty school industry is highly fragmented. As a result, we believe there is an opportunity to consolidate this industry through acquisition, as well. Expanding this business would allow us to add incremental revenue without cannibalizing our existing salon or hair restoration center businesses. Primarily through acquisition, we believe beauty schools could contribute over $100 million in annual revenue within a few years.
Our organic growth plans for the beauty school business include the construction of new locations; however, due to Department of Education policies, we will be limited in the number of new schools we are able to construct in the immediate future. The success of a beauty school location is not dependent on good visibility or strong customer traffic; however, access to parking and/or public transportation is important. The success of existing and newly constructed schools is dependent on effective marketing and recruiting to attract new enrollees.
For a discussion of our near-term expectations, please refer to the Investor Information section of our website at www.regiscorp.com.
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CRITICAL ACCOUNTING POLICIES
The Condensed Consolidated Financial Statements are prepared in conformity with accounting principles generally accepted in the United States of America. In preparing the Condensed Consolidated Financial Statements, we are required to make various judgments, estimates and assumptions that could have a significant impact on the results reported in the Condensed Consolidated Financial Statements. We base these estimates on historical experience and other assumptions believed to be reasonable under the circumstances. Changes in these estimates could have a material effect on our Condensed Consolidated Financial Statements.
Our significant accounting policies can be found in Note 1 to the Consolidated Financial Statements contained in Part II, Item 8 of the June 30, 2004 Annual Report on Form 10-K/A, as well as Note 1 to the Condensed Consolidated Financial Statements contained within this Quarterly Report on Form 10-Q. We believe the accounting policies related to the valuation of goodwill, the valuation and estimated useful lives of long-lived assets, purchase price allocations, revenue recognition, the cost of product used and sold, self-insurance accruals, legal contingencies and estimates used in relation to tax liabilities and deferred taxes are most critical to aid in fully understanding and evaluating our reported financial condition and results of operations. Discussion of each of these policies is contained under “Critical Accounting Policies” in Part II, Item 7 of our June 30, 2004 Annual Report on Form 10-K/A. Below is an addition to our critical accounting policies disclosure as of June 30, 2004.
Goodwill
We review goodwill for impairment annually or at any time events or circumstances indicate that the carrying value may not be fully recoverable. According to our accounting policy, an annual review is performed in the third quarter of each year, or more frequently if indicators of potential impairment exist. Our impairment review process is based on a discounted future cash flow approach that uses estimates of revenues for the reporting units, driven by assumed organic growth rates, estimated future gross margin and expense rates, as well as acquisition integration and maturation, and appropriate discount rates. These estimates are consistent with the plans and estimates that are used to manage the underlying businesses. Charges for impairment of goodwill for a reporting unit may be incurred if the reporting unit fails to achieve its assumed revenue growth rates or assumed gross margin, or if interest rates increase significantly. We generally consider our various concepts to be reporting units when we test for goodwill impairment because that is where we believe goodwill naturally resides.
During the quarter ending March 31, 2005, we reduced our expectations for the European business based on recent growth trends. Based on the results of our third quarter fiscal year 2005 goodwill impairment testing, which factored in these revised growth trend expectations, we wrote down the carrying value of the European business to reflect its estimated fair value. As a result, we recorded a pre-tax, non-cash charge of $38.3 million during the third quarter. Two of the most significant assumptions underlying the determination of fair value of goodwill are discount rates and tax rates. In connection with the measurement we performed during the third quarter, a 100 basis point increase in the discount rate we used would have resulted in an impairment charge of approximately $42.1 million instead of $38.3 million, while a 100 basis point decrease in the discount rate would have resulted in an impairment charge of approximately $34.5 million. Additionally, a five percent increase in the tax rate we used would have resulted in an impairment charge of approximately $40.3 million instead of $38.3 million, while a five percent decrease in the tax rate would have resulted in an impairment charge of approximately $37.3 million.
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RESULTS OF OPERATIONS
Consolidated Results of Operations
The following table sets forth, for the periods indicated, certain information derived from our Condensed Consolidated Statements of Operations, expressed as a percent of revenues. The percentages are computed as a percent of total consolidated revenues, except as noted.
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Consolidated Revenues
Consolidated revenues include revenues of company-owned salons, product and equipment sales to franchisees, beauty school revenues, hair restoration center revenues, and franchise royalties and fees. During the third quarter and first nine months of fiscal year 2005, consolidated revenues increased 15.8 percent to $557.3 million and 13.2 percent to $1.6 billion, respectively, as compared to the corresponding periods of the prior fiscal year. The following table details our consolidated revenues by concept:
Salon same-store sales increases or decreases are calculated on a daily basis as the total change in sales for company-owned salons which were open on a specific day of the week during the current period and the corresponding prior period. Quarterly and year-to-date salon same-store sales increases are the sum of the same-store sales increases computed on a daily basis. Relocated salons are included in same-store sales as they are considered to have been open in the prior period. International same-store sales are calculated in local currencies so that foreign currency fluctuations do not impact the calculation. Management believes that same-store sales, a component of organic growth, are useful in order to help determine the increase in salon revenues attributable to its organic growth (new salon construction and same-store sales growth) versus growth from acquisitions.
The 15.8 and 13.2 percent increases in consolidated revenues during the three and nine months ended March 31, 2005, respectively, were driven by the following:
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We acquired 563 company-owned salons (including 129 franchise salon buybacks), 90 company-owned hair restoration centers and 14 company-owned beauty schools during the twelve months ended March 31, 2005. The organic growth stemmed from the construction of 510 company-owned salons during the twelve months ended March 31, 2005, as well as consolidated same-store sales increases. During the third quarter and first nine months of fiscal year 2005, the foreign currency impact was driven by the further weakening of the United States dollar against the British pound, Euro and Canadian dollar as compared to the prior periods’ exchange rates. The impact of foreign currency was calculated by multiplying current year revenues in local currencies by the change in the foreign currency exchange rate between the current fiscal year and the prior fiscal year.
Consolidated revenues are primarily comprised of service and product revenues, as well as franchise royalties and fees. Fluctuations in these three major revenue categories were as follows:
Service Revenues. Service revenues include revenues generated from company-owned salons, tuition and service revenues generated within our beauty schools, and service revenues generated by hair restoration centers. For the three and nine months ended March 31, 2005 and 2004, total service revenues were as follows:
The growth in service revenues in the third quarter and first nine months of fiscal year 2005 were driven primarily by acquisitions and organic growth in our salons (new salon construction and same-store sales growth). Salon service revenues for the quarter and nine months ended March 31, 2005 were positively impacted by the shift in Easter from the fourth quarter of the prior fiscal year to the third quarter of the current fiscal year.
Product Revenues. Product revenues are primarily comprised of retail sales at company-owned salons, sales of product and equipment to franchisees, and retail product sales made by our beauty schools and hair restoration centers. Total product revenues for the three and nine months ended March 31, 2005 and 2004 were as follows:
Fiscal year 2005 product revenue percentage increases were not as robust as in the corresponding periods of the prior fiscal year primarily due to lower same-store product sales increases in our company-owned salons. The large increase in same-store product sales during fiscal year 2004 was primarily driven by a trend towards sales of higher priced beauty tools, such as flat irons.
Franchise Royalties and Fees. Total franchise revenues, which include royalties and franchise fees, were as follows:
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Total franchise locations open at March 31, 2005 and 2004 were 3,929 (including 49 franchise hair restoration centers) and 3,900, respectively. We purchased 129 of our franchise salons during the twelve months ended March 31, 2005, which drove the overall decrease in the number of franchise salons between periods.
The increase in consolidated franchise revenues during the three and nine months ended March 31, 2005 was primarily due to favorable foreign currency exchange rate fluctuations, which caused franchise revenues to increase 2.9 and 3.8 percent, respectively. Exclusive of the effect of this favorable currency fluctuation, consolidated franchise revenues increased 5.3 and 2.8 percent in the quarter and nine months ended March 31, 2005, respectively. These increases were primarily due to opening more new international franchise salons during the first nine months of fiscal year 2005 as compared to the first nine months of the prior fiscal year, as well as the acquisition of 49 franchise hair restoration centers.
Gross Margin
Our cost of revenues primarily includes labor costs related to salon employees, beauty school instructors and hair restoration center employees, the cost of product used in providing services and the cost of products sold to customers and franchisees. The resulting gross margin for the three and nine months ended March 31, 2005 and 2004 was as follows:
Service Margin. Service margin for the third quarter and first nine months of fiscal year 2005 and 2004 was as follows:
The basis point decrease in service margins during the three and nine months ended March 31, 2005 was primarily related to increased salon payroll costs in the United Kingdom salons, as well as higher salon supply costs during the third quarter. Additionally, certain of our domestic salons experienced increased heath insurance costs.
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Product Margin. Product margin for the third quarter and first nine months of fiscal year 2005 and 2004 was as follows:
The improvement in product margins for the third quarter and first nine months of fiscal year 2005 was due to the impact of product sales in the hair restoration centers, which have higher product margins than our salon business. This favorable impact was softened by an upward adjustment to the usage percentage to reflect current trends towards the sale of higher-priced products and an increase to our slow-moving product reserve in response to changing product lines.
Site Operating Expenses
This expense category includes direct costs incurred by our salons, beauty schools and hair restoration centers, such as on-site advertising, workers’ compensation, insurance, utilities and janitorial costs. Site operating expenses for the third quarter and first nine months of fiscal year 2005 and 2004 were as follows:
The basis point improvement in site operating expenses during the quarter and nine months ended March 31, 2005 was primarily due to the addition of the hair restoration centers in December 2004, which have lower site operating expenses as a percentage of revenue. Additionally, advertising expenses were higher in the third quarter of the prior year stemming from the timing of a direct mail campaign.
General and Administrative
General and administrative (G&A) includes costs associated with our field supervision, salon training and promotions, product distribution centers and corporate offices (such as salaries and professional fees), including costs incurred to support franchise, beauty school and hair restoration center operations. During the three and nine months ended March 31, 2005 and 2004, G&A costs were as follows:
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The increase in G&A costs as a percent of total revenues during the third quarter and first nine months of fiscal year 2005 was primarily due to increased professional fees related to the June 30, 2005 Sarbanes-Oxley 404 compliance effort and legal fees related to the Fair Labor Standards Act. Health insurance costs also increased throughout fiscal year 2005, as well as increased costs due to a new AS/400 computer operating lease. In addition, the hair restoration centers have slightly higher G&A costs as a percent of revenues due to the marketing-intensive nature of that business.
Rent
Rent expense, which includes base and percentage rent, common area maintenance and real estate taxes, was as follows:
The increase in this fixed-cost expense as a percent of total revenues was primarily due to rent increasing at a faster rate than salon same-store sales during the third quarter and first nine months of fiscal year 2005.
Depreciation and Amortization
Depreciation and amortization expense (D&A) for the three and nine months ended March 31, 2005 and 2004 was as follows:
The basis point increase in this expense category as a percent of total revenues was primarily due to amortization of intangible assets that we acquired in the acquisition of the hair restoration centers during the second quarter of the current fiscal year.
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Interest
Interest expense was as follows:
The increase in interest expense as a percent of total revenues during the third quarter and first nine months of fiscal year 2005 was primarily due to an increase in our debt level stemming from our current year acquisition activity, including the hair restoration centers and additional beauty schools.
Income Taxes
Our reported effective tax rate was as follows:
The increase in our overall effective tax rate for the three and nine months ended March 31, 2005 was solely related to the goodwill impairment charge in the international salon segment, which is non-deductible for tax purposes. Excluding the impact of the goodwill impairment charge, our effective tax rate improved by 150 and 160 basis points during the three and nine months ended March 31, 2005, respectively, primarily due to the reinstated Work Opportunity Credit during fiscal year 2005 (see Note 8 to the Condensed Consolidated Financial Statements) and an increase in the mix of earnings from our international salons.
Recent Accounting Pronouncements
Recent accounting pronouncements are discussed in Note 1 to the Condensed Consolidated Financial Statements.
Effects of Inflation
We compensate some of our salon employees with percentage commissions based on sales they generate, thereby enabling salon payroll expense as a percent of company-owned salon revenues to remain relatively constant. Accordingly, this provides us certain protection against inflationary increases, as payroll expense and related benefits (our major expense components) are variable costs of sales. In addition, we may increase pricing in our salons to offset any significant increases in wages. Therefore, we do not believe inflation has had a significant impact on the results of operations.
Constant Currency Presentation
The presentation below demonstrates the effect of foreign currency exchange rate fluctuations from year to year. In the third quarter and first nine months of fiscal year 2005, foreign currency translation had a positive impact on consolidated revenues due to the strengthening of the Canadian dollar, British pound and Euro. To present this information, current period results for entities reporting in currencies other than United States dollars are converted into United States dollars at the average exchange rates in effect during the corresponding period of the prior fiscal year, rather than the actual average exchange rates in effect during the current fiscal year. Therefore, the foreign currency impact is equal to current year results in local currencies multiplied by the change in the average foreign currency exchange rate between the current fiscal period and the corresponding period of the prior fiscal year.
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Results of Operations by Segment
Based on our internal management structure, we report four segments: North American salons, international salons, beauty schools and hair restoration centers. Significant results of operations are discussed below with respect to each of these segments.
North American Salons
North American Salon Revenues. Total North American salon revenues were as follows:
The percentage increases during the three and nine months ended March 31, 2005 were due to the following factors:
We acquired 546 company-owned North American salons during the twelve months ended March 31, 2005, including 129 franchise buybacks. The organic growth stemmed primarily from the construction of 490 company-owned salons in North America during the twelve months ended March 31, 2005. The foreign currency impact during the third quarter and first nine months of fiscal year 2005 was driven by the weakening of the United States dollar against the Canadian dollar as compared to the prior periods’ exchange rates
North American Salon Operating Income. Operating income for the North American salons for the third quarter and first nine months of fiscal year 2005 and 2004 was as follows:
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The decrease in North American salon operating income during the three and nine months ended March 31, 2005 was primarily related to decreased margins stemming from an upward adjustment to the usage percentage to reflect current trends towards the sale of higher-priced products and an increase to our slow-moving product reserve in response to changing product lines. Additionally, increased salon supply costs and an adjustment to the weighted average cost associated with our private label product line negatively impacted our product margins in the North American salons. Further, increased health care costs had a negative impact on North American operating income.
International Salons
International Salon Revenues. Total international salon revenues were as follows:
The percentage increases during the three and nine months ended March 31, 2005 were due to the following factors.
We acquired 17 company-owned international salons during the twelve months ended March 31, 2005. The organic growth stemmed from the construction of 20 company-owned international salons during the twelve months ended March 31, 2005, as well as international same-store sales increases. The foreign currency impact during the third quarter and first nine months of fiscal years 2005 was driven by the weakening of the United States dollar against the British pound and the Euro as compared to the prior periods’ exchange rates.
International Salon Operating Income (Loss). Operating income (loss) for the international salons for the third quarter and first nine months of fiscal year 2005 and 2004 was as follows:
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The decrease in International salon operating income during the three and nine months ended March 31, 2005 was primarily due to the goodwill impairment charge of $38.3 million during the third quarter of the current fiscal year. Two factors that lead to the impairment charge include a continuing trend toward longer hair styles and slower than expected growth of the European economy. See the Critical Accounting Policies section for further discussion. In addition to the impairment, slightly higher payroll costs also had a negative impact on operating income in the U.K. salons.
Beauty Schools
Beauty School Revenues. Total beauty schools revenues were as follows:
We acquired 14 beauty schools during the twelve months ended March 31, 2005. The foreign currency impact during the third quarter and first nine months of fiscal years 2005 was driven by the weakening of the United States dollar against the British pound as compared to the prior periods’ exchange rates.
Beauty School Operating Income. Operating income for our beauty schools for the third quarter and first nine months of fiscal year 2005 and 2004 was as follows:
We first began operating beauty schools during December 2002 (i.e., the second quarter of fiscal year 2003), in conjunction with the Vidal Sassoon acquisition. We have since expanded by acquiring six beauty schools during the fourth quarter of the prior fiscal year (i.e., fiscal year 2004), four beauty schools in the second quarter of fiscal year 2005 and four additional schools in the third quarter of fiscal year 2005. Therefore, the year-over-year fluctuations in beauty school operating income stem primarily from our integration of the new beauty schools and changes in the mix of beauty schools due to these acquisitions.
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Hair Restoration Centers
As discussed in Note 7 to the Condensed Consolidated Financial Statements, we acquired Hair Club for Men and Women in December 2004. Therefore, our operating results for the nine months ended March 31, 2005 include only four months of operations from this acquired entity (referred to as hair restoration centers for segment reporting purposes). Refer to Note 5 of the Condensed Consolidated Financial Statements for the results of operations related to the hair restoration centers which were included in our Condensed Consolidated Statement of Operations and Note 7 for related pro forma information.
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LIQUIDITY AND CAPITAL RESOURCES
Overview
We continue to maintain a strong balance sheet to support system growth and financial flexibility. Our debt to capitalization ratio, calculated as total debt as a percentage of total debt and shareholders’ equity at fiscal quarter end, was as follows:
The increase in debt over the prior fiscal year was driven by the $210 million acquisition of Hair Club for Men and Women with debt during December 2004, as well as over $100 million for the purchase of salons and beauty schools during the first nine months of fiscal year 2005. Our principal on-going cash requirements are to finance construction of new stores, remodel certain existing stores, acquire salons and beauty schools, and purchase inventory. Customers pay for salon services and merchandise in cash at the time of sale, which reduces our working capital requirements.
Total assets at March 31, 2005 and June 30, 2004 were as follows:
Acquisitions, including the acquisition of Hair Club for Men and Women in December 2004, were the primary driver of the increase in total assets between June 30 and March 31, 2005.
Total shareholders’ equity at March 31, 2005 and June 30, 2004 was as follows:
During the first nine months of fiscal year 2005, equity increased primarily as a result of net income, additional paid-in capital primarily recorded in connection with the exercise of stock options, increased accumulated other comprehensive income due to foreign currency translation adjustments as the result of the strengthening of foreign currencies that underlie our investments in those markets and stock issued in connection with acquisitions.
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Cash Flows
Operating Activities
Net cash provided by operating activities in the first nine months of fiscal year 2005 and 2004 was $171.4 and $162.0 million, respectively. The cash flows from operating activities were a result of the following:
During the first nine months of fiscal year 2005, accounts payable and accrued expenses increased primarily due to an increase in inventory, as well as the timing of advertising expenses and income taxes payments. Additionally, inventories increased due to growth in the number of salons, as well as lower than expected same-store product sales. The goodwill impairment charge resulted from a write-off related to the international salon segment, as discussed in the Critical Accounting Policies section.
Investing Activities
Net cash used in investing activities of $373.7 and $104.8 million in the first nine months of fiscal year 2005 and 2004, respectively, was the result of the following:
We constructed 373 company-owned salons, and acquired 396 company-owned salons (122 of which were franchise buybacks) and eight company-owned beauty schools during the first nine months of fiscal year 2005. Further, we acquired 42 company-owned and 49 franchise hair restoration centers during December of 2004 (see Note 7 to the Condensed Consolidated Financial Statements). Acquisitions were primarily funded by a combination of operating cash flows and debt. The company-owned constructed and acquired salons consisted of the following number of salons in each concept:
Additionally, we completed 145 major remodeling projects during the first nine months of fiscal year 2005.
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Financing Activities
The net borrowing on revolving credit facilities and net proceeds of long-term debt were primarily used to fund acquisitions, which are discussed in the paragraph below and in Note 7 to the Condensed Consolidated Financial Statements. The proceeds from the issuance of common stock were related to the exercise of stock options. In the third quarter of fiscal year 2004, the quarterly dividend was increased from its historical rate of $0.03 per share to $0.04 per share.
Acquisitions
Contractual Obligations and Commercial Commitments
Subsequent to the end of our third quarter in the current fiscal year, we amended and restated our existing revolving credit facility, thereby increasing our borrowing capacity under this facility by $100 million (to $350 million). Additionally, we incurred $200 million of new private placement debt. See Note 9 to the Condensed Consolidated Financial Statements, as well as our Form 8-K filed with the SEC on April 12, 2005, for further discussion. There have been no other significant changes in our commercial commitments such as commitments under lines of credit or standby letters of credit since June 30, 2004. We are in compliance with all covenants and other requirements of our credit agreements and indentures. Additionally, the credit agreements do not include rating triggers or subjective clauses that would accelerate maturity dates.
As a part of our salon development program, we continue to negotiate and enter into leases and commitments for the acquisition of equipment and leasehold improvements related to future salon locations, and continue to enter into transactions to acquire established hair care salons and businesses.
Prior to December 31, 2002, we became guarantor on a limited number of equipment lease agreements between our franchisees and leasing companies. If the franchisee should fail to make payments in accordance with the lease, we will be held liable under such agreements and retain the right to possess the related salon operations. We believe the fair value of the salon operations exceeds the maximum potential amount of future lease payments for which we could be held liable. The existing guaranteed lease obligations, which have an aggregate undiscounted value of $2.1 million at March 31, 2005, terminate at various dates between June 2006 and April 2009. We have not experienced, and do not expect, any material loss to result from these arrangements.
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Financing
We believe that cash generated from operations and amounts available under our existing debt facilities will be sufficient to fund anticipated capital expenditures, acquisitions and required debt repayments for the foreseeable future.
Dividends
Share Repurchase Program
Risk Factors
Impact of Acquisition and Real Estate AvailablityThe key driver of our revenue and earnings growth is the number of locations we acquire or construct. While we believe that substantial future acquisition and organic growth opportunities exist, any material decrease in the number of such opportunities would have an impact on our revenue and earnings growth.
Impact of the Economic EnvironmentChanges to the United States, Canadian, United Kingdom and other European economies have an impact on our business. Visitation patterns to our salons and hair restoration centers can be adversely impacted by changes in unemployment rates and discretionary income levels.
Impact of Key RelationshipsWe maintain key relationships with certain companies. Termination of these relationships could have an adverse impact on our ability to grow or future operating results.
Impact of FashionChanges in consumer tastes and fashion trends can have an impact on our financial performance.
Impact of Changes in Regulatory and Statutory LawsWith more than 10,000 locations and an average of 52,000 corporate employees world-wide, our financial results can be adversely impacted by regulatory or statutory changes in laws.
Impact of CompetitionCompetition on a market by market basis remains strong. Therefore, our ability to raise prices in certain markets can be adversely impacted by this competition.
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Impact of Changes in Manufacturers’ Choice of Distribution ChannelsThe retail products that we sell are licensed to be carried exclusively by professional salons. Should the various product manufacturers decide to utilize other distribution channels, such as large discount retailers, it could negatively impact the revenue earned from product sales.
Impact of Changes to Interest Rates and Foreign Currency Exchange RatesChanges in interest rates will have an impact on our expected results from operations. Currently, we manage the risk related to fluctuations in interest rates through the use of floating rate debt instruments and other financial instruments. See discussion in Item 3., “Quantitative and Qualitative Disclosures about Market Risk,” for additional information.
Changes in foreign currency exchange rates will have an impact on our reported results from operations. The majority of the revenue and costs associated with the performance of our foreign operations are denominated in local currencies such as the Canadian dollar, Euro and British pound. Therefore, we do not have significant foreign currency transaction risk; however, the translation at different exchange rates from period to period may impact the amount of reported income from our international operations. Refer the constant currency discussion in “Management’s Discussion and Analysis” for further detail.
Impact of SeasonalityOur business is not subject to substantial seasonal variations in demand. However, the timing of Easter may cause a quarterly variation in the third and fourth quarters. Historically, our revenue and net earnings have generally been realized evenly throughout the fiscal year. The service and retail product revenues associated with our corporate salons, as well as our franchise revenues, are of a replenishment nature. We estimate that customer visitation patterns are generally consistent throughout the year.
Impact of Changes in Securities Laws and RegulationsThe Sarbanes-Oxley Act of 2002 that became law in July 2002 requires changes in some of our corporate governance and securities disclosure or compliance practices. We are presently preparing for our required compliance with the Sarbanes-Oxley Act of 2002, and management’s assertion concerning financial reporting controls. While we believe that we can ultimately comply with the new legislated requirements associated with being a registrant with the Securities and Exchange Commission, this process is costly and presents both challenge and risk.
The Sarbanes-Oxley Act of 2002 also requires the SEC to promulgate new rules on a variety of subjects, in addition to rule proposals already made, and the New York Stock Exchange has approved revisions to its requirements for listed companies. We expect these developments to increase our compliance costs. These developments could possibly make it more difficult and more expensive to obtain director and officer liability insurance, and we may be required to accept reduced coverage or incur substantially higher costs to obtain coverage. These developments could make it more difficult for us to attract and retain qualified members of our board of directors, or qualified executive officers.
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SAFE HARBOR PROVISIONS UNDER THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995
This quarterly report on Form 10-Q, as well as information included in, or incorporated by reference from, future filings by the Company with the Securities and Exchange Commission and information contained in written material, press releases and oral statements issued by or on behalf of the Company contains or may contain “forward-looking statements” within the meaning of the federal securities laws, including statements concerning anticipated future events and expectations that are not historical facts. These forward-looking statements are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. The forward-looking statements in this document reflect management’s best judgment at the time they are made, but all such statements are subject to numerous risks and uncertainties, which could cause actual results to differ materially from those expressed in or implied by the statements herein. Such forward-looking statements are often identified herein by use of words including, but not limited to, “may,” “believe,” “project,” “forecast,” “expect,” “estimate,” “anticipate,” and “plan.” In addition, the following factors could affect the Company’s actual results and cause such results to differ materially from those expressed in forward-looking statements. These factors include competition within the personal hair care industry, which remains strong, both domestically and internationally, and price sensitivity; changes in economic condition; changes in consumer tastes and fashion trends; labor and benefit costs; legal claims; risk inherent to international development (including currency fluctuations); the continued ability of the Company and its franchisees to obtain suitable locations and financing for new salon development; governmental initiatives such as minimum wage rates, taxes and possible franchise legislation; the ability of the Company to successfully identify and acquire salons and beauty schools that support its growth objectives; changes in key relationships with certain companies; changes in regulatory and statutory laws; changes in manufacturers’ choice of distribution channels; or other factors not listed above. The ability of the Company to meet its expected revenue growth is dependent on salon acquisitions, new salon construction and same-store sales increases, all of which are affected by many of the aforementioned risks. Additional information concerning potential factors that could affect future financial results is set forth herein and in the Company’s Annual Report on Form 10-K for the year ended June 30, 2004 and incorporated by reference into Form S-3 Registration Statement filed with the Securities and Exchange Commission on June 4, 2004. We undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. However, your attention is directed to any further disclosures made in our subsequent annual and periodic reports filed or furnished with the SEC on Forms 10-Q and 8-K and Proxy Statements on Schedule 14A.
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Item 3. Quantitative and Qualitative Disclosures about Market Risk
The primary market risk exposure of the Company relates to changes in interest rates in connection with its debt, some of which bears interest at floating rates based on LIBOR plus an applicable borrowing margin. Additionally, the Company is exposed to foreign currency translation risk related to its net investments in its foreign subsidiaries. The Company has established policies and procedures that govern the management of these exposures. By policy, the Company does not enter into such contracts for the purpose of speculation. The following details the Company’s policies and use of financial instruments.
Interest Rate Risk:The Company has established an interest rate management policy that attempts to minimize its overall cost of debt, while taking into consideration the earnings implications associated with the volatility of short-term interest rates. As part of this policy, the Company has elected to maintain a combination of floating and fixed rate debt. As of March 31, 2005 and June 30, 2004, the Company had the following outstanding debt balances, considering the effect of interest rate swaps and including $2.1 and $3.5 million related to the fair value swaps at March 31, 2005 and June 30, 2004, respectively:
In addition, the Company has entered into the following financial instruments:
Interest Rate Swap Contracts:The Company manages its interest rate risk by balancing the amount of fixed and floating rate debt. On occasion, the Company uses interest rate swaps to further mitigate the risk associated with changing interest rates and to maintain its desired balances of fixed and floating rate debt. Generally, the terms of the interest rate swap agreements contain quarterly settlement dates based on the notional amounts of the swap contracts.
(Pay fixed rates, receive variable rates)
During the third quarter of fiscal year 2005, the Company entered into two treasury lock agreements for the purpose of establishing the effective interest rate on anticipated private placement debt, the agreement for which was subsequently finalized on April 7, 2005 (see Note 9, “Subsequent Event”). The treasury lock agreements were designated as a cash flow hedge of the fluctuations in the Treasury rate component of the then forecasted fixed coupon payments due to changes in the benchmark interest rate, with the changes in the value of the treasury lock expected to completely offset the changes in the value of the Treasury rate component of the fixed coupon payments. The contracts had notional amounts of $50.0 and $25.0 million and were tied to the U.S. government ten-year and interpolated eight-year treasury note rates, respectively. Upon settlement of the agreements in March 2005, the Company incurred an unrecognized gain of approximately $0.8 million on the contracts. This gain is deferred within accumulated other comprehensive income, a component of shareholders’ equity on the Consolidated Balance Sheet. Just over half of the $0.8 million deferred gain will be amortized as a reduction to interest expense through 2013, with the remainder being amortized through 2015.
The cumulative tax-effected net loss recorded in other comprehensive income, set forth under the caption shareholders’ equity in the Condensed Consolidated Balance Sheet, related to the cash flow hedges, including the treasury lock agreements discussed in the preceding paragraph, was $0.4 million at March 31, 2005 and 2004, respectively. The following table depicts the hedging activity recorded in the accumulated other comprehensive income account related to these cash flow hedges for the three and nine months ended March 31, 2005 and 2004.
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(Pay variable rates, receive fixed rates)
The Company’s fair value swaps are recorded at fair value within other assets in the Condensed Consolidated Balance Sheet, with a corresponding cumulative adjustment to the underlying senior term note within long-term debt of $1.2 and $2.4 million at March 31, 2005 and June 30, 2004, respectively. Additionally, $0.9 and $1.1 million of deferred gain remained in long-term debt at March 31, 2005 and June 30, 2004, respectively, related to the early termination of a fair value swap contract. No hedge ineffectiveness occurred during the first half of fiscal year 2005 or 2004. As a result, the fair value swaps did not have a net impact on earnings.
Foreign Currency Exchange Risk:The majority of the Company’s revenue, expense and capital purchasing activities are transacted in United States dollars. However, because a portion of the Company’s operations consists of activities outside of the United States, the Company has transactions in other currencies, primarily the Canadian dollar, British pound and Euro. In preparing the Condensed Consolidated Financial Statements, the Company is required to translate the financial statements of its foreign subsidiaries from the currency in which they keep their accounting records, generally the local currency, into United States dollars. Different exchange rates from period to period impact the amounts of reported income and the amount of foreign currency translation recorded in accumulated other comprehensive income. As part of its risk management strategy, the Company frequently evaluates its foreign currency exchange risk by monitoring market data and external factors that may influence exchange rate fluctuations. As a result, the Company may engage in transactions involving various derivative instruments to hedge assets, liabilities and purchases denominated in foreign currencies. As of March 31, 2005, the Company has entered into the following financial instrument:
Hedge of the Net Investment in Foreign Subsidiaries:The Company has a cross-currency swap with a notional amount of $21.3 million to hedge a portion of its net investments in its foreign operations. The purpose of this hedge is to protect against adverse movements in exchange rates. The cross-currency swap hedged approximately eight and seven percent of the Company’s net investments in foreign operations at March 31, 2005 and June 30, 2004, respectively.
The Company’s cross-currency swap is recorded at fair value within other noncurrent liabilities in the Condensed Consolidated Balance Sheet. At March 31, 2005 and June 30, 2004, the Company’s net investment in this derivative financial instrument was in a $10.8 and $8.7 million loss position, respectively, based on its estimated fair value. The corresponding tax-effected offset is charged to the cumulative translation adjustment account, which is a component of accumulated other comprehensive income set forth under the caption shareholders’ equity in the Condensed Consolidated Balance Sheet. For the quarters ended March 31, 2005 and 2004, $0.8 and $0.3 million of tax-effected gain related to this derivative was charged to the cumulative translation adjustment account, respectively. For the nine months ended March 31, 2005 and 2004, $1.9 and $2.1 million of tax-effected loss related to this derivative was charged to the cumulative translation adjustment account, respectively.
For additional information, including a tabular presentation of the Company’s debt obligations and derivative financial instruments, refer to Part II, Item 7A, “Quantitative and Qualitative Disclosures About Market Risk,” in the Company’s June 30, 2004 Annual Report on Form 10-K/A. Other than the information included above, there have been no material changes to this information during the nine months ended March 31, 2005.
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Item 4. Controls and Procedures
Evaluation of Disclosure Controls and ProceduresThe Company maintains disclosure controls and procedures that are designed to ensure that information required to be disclosed in its Exchange Act reports is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms, and that such information is accumulated and communicated to management, including the chief executive officer and chief financial officer, as appropriate, to allow timely decisions regarding required disclosure. Management necessarily applied its judgment in assessing the costs and benefits of such controls and procedures, which, by their nature, can provide only reasonable assurance regarding management’s control objectives.
With the participation of management, the Company’s chief executive officer and chief financial officer evaluated the effectiveness of the design and operation of the Company’s disclosure controls and procedures at the conclusion of the period ended March 31, 2005. Based upon this evaluation, the chief executive officer and chief financial officer concluded that the Company’s disclosure controls and procedures were effective at the reasonable assurance level.
Management’s Consideration of the RestatementIn coming to the conclusion that our internal control over financial reporting was effective as of March 31, 2005, our management considered, among other things, the control deficiency related to the determination of lease terms, which resulted in the need to restate our previously issued financial statements as disclosed in Note 2 of Notes to Condensed Consolidated Financial Statements included in this Form 10-Q. After reviewing and analyzing the Securities and Exchange Commission’s Staff Accounting Bulletin (“SAB”) No. 99, “Materiality,” Accounting Principles Board Opinion No. 28, “Interim Financial Reporting,” paragraph 29 and SAB Topic 5-F, “Accounting Changes Not Retroactively Applied Due to Immateriality,” and taking into consideration (i) that the restatement adjustments did not have a material impact on the financial statements of prior interim or annual periods taken as a whole; (ii) that the cumulative impact of the restatement adjustments on stockholders’ equity was not material to the financial statements of prior interim or annual periods; and (iii) that we decided to restate our previously issued financial statements solely because the cumulative impact of the error, if recorded in the current period, would have been material to the current year’s reported net income, our management concluded that the control deficiency that resulted in the restatement of the prior period financial statements was not in itself a material weakness.
Changes in Internal ControlsThere were no changes in the Company’s internal controls or, to the knowledge of management of the Company, in other factors that could significantly affect internal controls over financial reporting that occurred during the Company’s most recent fiscal quarter based on the Company’s most recent evaluation of its disclosure controls and procedures utilized to compile information included in this filing.
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Part II – Other Information
Item 1. Legal Proceedings
The Company is a defendant in various lawsuits and claims arising out of the normal course of business. Like certain other large retail employers, the Company has been faced with allegations of purported class-wide wage and hour violations. The Company is currently a defendant in a collective action lawsuit in which the plaintiffs allege violations under the Fair Labor Standards Act (“FLSA”). The Company denies these allegations and will actively defend its position. However, litigation is inherently unpredictable and the outcome of these matters cannot presently be determined. Although company counsel believes that the Company has valid defenses in these matters, it could in the future incur judgments or enter into settlements of claims that could have a material adverse effect on its results of operations in any particular period.
Item 2. Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities
(e) Share Repurchase Program
The Company’s Board of Directors approved a stock repurchase program under which up to $100.0 million can be expended for the repurchase of the Company’s common stock. The timing and amounts of any repurchases will depend on many factors, including the market price of the common stock and overall market conditions. All repurchased shares are immediately retired. This repurchase program has no stated expiration date.
All repurchases of the Company’s common stock during the quarter ended March 31, 2005 were part of this repurchase program. The following table shows the monthly third quarter fiscal year 2005 stock repurchase activity:
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Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits:
(b) Reports on Form 8-K:
The following reports on Form 8-K were filed during the three months ended March 31, 2005:
Form 8-K dated January 4, 2005 related to the announcement of revised expectations related to its consolidated revenues and earnings growth for each of the remaining three fiscal quarters in its current fiscal year, as well as a revised outlook for full fiscal year.
Form 8-K dated January 7, 2005 related to the announcement of the Company’s consolidated revenues and consolidated same-store sales for the month and quarter ended December 31, 2004.
Form 8-K dated January 24, 2005 related to the announcement of the overview of the fiscal year 2005 acquisition activity.
Form 8-K dated January 26, 2005 related to the announcement of the Company’s financial results for its fiscal second quarter ended December 31, 2004.
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SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
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