Item 1A. Risk Factors
The impact of the COVID-19 pandemic and the measures implemented to contain the spread of the virus have had, and are expected to continue to have, a material adverse impact on our business and results of operations.
Our operations expose us to risks associated with public health crises and epidemics/pandemics, such as the novel strain of coronavirus (COVID-19) that has spread globally. COVID-19 has had, and will continue to have, an adverse impact on our operations, including the temporary closure of all of our company-owned salons and almost all of our franchise locations for most of the fourth quarter of fiscal year 2020; implementation of a furlough program in the fourth quarter for a substantial majority of our workforce across our corporate office, field support and distribution centers; and temporary reductions in the pay for executives and other working employees at different levels for approximately two months during the fourth quarter of fiscal year 2020. The pandemic may affect the health and welfare of our stylist community, customers, franchise partners or headquarters personnel. As of the date of this filing, a majority of our company-owned and franchise salons have re-opened after having been temporarily closed for several weeks and/or months during the fourth quarter of fiscal year 2020. While most of our salons have been able to re-open, we expect that states may decide to again require the closure of salons as the level of COVID-19 positive cases continue to fluctuate, as we have already seen in California. Each time we are required to close and re-open salons, we will continue to experience the risks and business impacts described here, and further requirements to again close salons or limit and/or modify services or operations may exacerbate these impacts.
The unprecedented uncertainty surrounding COVID-19, including the rapidly changing governmental directives, public health challenges and progress, macroeconomic consequences and market reactions thereto, makes it more challenging for our management to estimate the future performance of our business and develop strategies to resume and/or continue operations or generate growth or achieve our initial or any revised objectives for calendar year 2020 and fiscal year 2021. In particular, the uncertainty around COVID-19 will likely delay and/or impair our ability to convert to a fully-franchised model by the end of calendar year 2020 as we had previously expected or for the net cash proceeds we had expected, and we may need to explore other transactions, such as closing or selling off certain salons.
In addition, as our stores are able to resume operations, some of our franchisees, many of whom were in the early stages of developing their businesses prior to the onset of the pandemic, have chosen or may choose not to due to a variety of factors, resume operation of their salons and/or they are facing challenges rehiring employees, reestablishing operations with their landlords and other vendors, and attracting customers back to their salons. As a result, in addition to our prior decision to suspend collection of franchise ad fund fees from our franchisees from April 1, 2020 through June 30, 2020, many of our franchisees have requested reductions or other modifications to their royalty payments or other amounts due to us, which may be critical to their ability to reestablishing operations, and they may simply be unable or unwilling to make lease, royalty or other payments to us and may be unable to continue to operate or need to close the salon. The removal or reduction of these payments, including the added expense associated with closed locations where the Company may have residual lease liability, has and is expected to continue to adversely impact our revenues and cash flows. Customers and employees may be cautious about returning to personal service providers, and we and our franchisees are incurring substantial additional costs to ensure the safety of our employees and customers. While we may experience an initial increased customer demand for our services and products when businesses’ resume operation, there is no assurance that such immediate increase will be sustained. Furthermore, many of our customers have themselves experienced adverse financial impacts from the pandemic, including loss of disposable income, which may limit their spending on personal care, including purchasing of beauty products, or have identified other means for hair care during the pandemic. The trend of increased remote work and utilization of advanced video-conferencing technology has led to a less-formal work environment which could impact the frequency of our hair care services. In addition, efforts to lift restrictions on individuals’ daily activities and businesses’ normal operations may result in a resurgence of COVID-19 and potentially prolong and intensify the impact of the crisis, including additional workers compensation claims and customer claims associated with the pandemic. Further, the pandemic could impact workers at our headquarters or compromise the performance of our Fremont, CA technology center.
As a result, COVID-19 has and will continue to negatively affect our revenue, increase the cost of salon operations, increase our investment in safety equipment and potentially expose us to additional liability, the combination of which will reduce our profitability, including the profitability of our franchisees. In addition, we retain residual real estate lease liability of $817.7 million for company-owned and nearly all franchise stores. The combination of the revenue reduction, obligations we ultimately owe to landlords, and other costs both related and unrelated to COVID-19 could significantly reduce or exhaust our available liquidity over time and limit our ability to access liquidity sources. While the economic impact of COVID-19 to our franchisees may be reduced by financial assistance under the Coronavirus Aid, Relief, and Economic Security (CARES) Act or other similar COVID-19 related federal and state programs, such programs may not have a positive impact on our corporate financial results and we believe we are currently ineligible for these programs.
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Among other things, while we have begun to call employees back to work, the temporary furlough of most of our employees has impacted various operational and risk management functions, including our audit and financial reporting function. These reductions could temporarily impair our ability to timely and accurately report information to regulators and our shareholders and impair our business risk management protocols. Additionally, some stylist employees have chosen not to return to the salon environment during the time of COVID-19.
We cannot reasonably estimate the length or severity of the COVID-19 pandemic, but we currently anticipate a material adverse impact on our financial position and results of operations. The disruption to the global economy and to our business, along with a sustained decline in our stock price, may lead to triggering events that may indicate that the carrying value of certain assets, including accounts receivables, long-lived assets, intangibles, and goodwill, may not be recoverable. Assessing goodwill for impairment requires management to make assumptions and to apply judgment, including forecasting future sales and expenses, and selecting appropriate discount rates, which can be affected by economic conditions and other factors that can be difficult to predict. Prior to the COVID-19 pandemic, the Company had been derecognizing Company-owned goodwill as part of the calculation of gain or loss on the sale of salons to franchisees. Based on the results of items referenced above, the Company recognized a non-cash impairment charge to fully impair the carrying value of goodwill related to our Company-owned reporting unit in the third quarter of fiscal year 2020.
COVID-19, and the volatile local, regional and global economic conditions stemming from the pandemic, as well as reactions to future pandemics or resurgences of COVID-19, including government mandates, could also precipitate or aggravate the other risk factors identified in this Form 10-K, which in turn could materially adversely affect our business, financial condition, liquidity, results of operations (including revenues and profitability) and/or stock price. Further, COVID-19 may also affect our operating and financial results, certain litigation or regulatory risks or the value of our salon brands in a manner that is not presently known to us or that we currently do not consider to present significant risks to our operations.
To date we have been successful in selling our company-owned salons to franchise owners and we are re-engineering our corporate and field infrastructure to support a fully-franchised portfolio, which involves risks to our financial condition and results of operations in both our company-owned and franchise portfolios.
We have been successful in selling our company-owned salons to franchise owners and, as a result, our inability to re-engineer the infrastructure and reduce our costs on timing and in amounts necessary to effectively support a fully-franchised salon portfolio may reduce the anticipated economic benefit of the transformation in the near term. Furthermore, our efforts to re-engineer and reduce the corporate and field infrastructure devoted to supporting company-owned stores may impair our ability to effectively support the remaining company-owned salons and diminish the value of those salons while we own them, which challenges our ability to sell such salons to franchisees, and adversely impacts the timing of venditions and net cash proceeds we generate from the sales process. In addition, as a result of the impacts of the COVID-19 pandemic, all company-owned salons were temporarily closed for several weeks, which has caused, among other things, a loss of stylists and customers, and which could diminish the value and timing of the salons in any future transfer of the ownership as part of our continued commitment to converting to a fully-franchised model.
We are now substantially dependent on franchise royalties and product sales and the overall success of our franchisees’ salons. It customarily takes new franchisees time to develop their salons and increase their sales. Further, a number of our historically successful and more experienced franchisees are onboarding new salon operations. This could adversely impact our revenue and profitability during this next stage of our transformation. Additionally, we expect that our franchisees will purchase products and services from us for their businesses, but there is no assurance that they will do so in quantities or at wholesale pricing levels consistent with our expectations or past practices. Further, in order to support and enhance our franchisees’ businesses, we may need to invest in certain unanticipated new capabilities and/or services, and we will need to determine the appropriate amount of investment to optimize the success of our franchisees, while ensuring that the level of investment supports our expected return on those investments. If we are not able to identify the right level of support and effectively deliver those resources to our franchisees, our results of operations and business may be adversely affected. Furthermore, our transition to a fully-franchised model may expose us to additional legal, compliance and operational risks specific to this different business model, including the business failure of unproven new salon owners.
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We have made significant investments in company-owned technology, including a new back office salon management system that may not yield results on the timing or amounts we expect due to the COVID-19 pandemic and pending litigation that has been filed by our existing back office salon management system supplier.
Investments made in company-owned technology, including the Company's new, internally developed back office salon management system, OpenSalon Pro, may not yield the profitable results on the timing or in amounts that we anticipate. Further, the COVID-19 pandemic may impact our ability to successfully launch this new system on the timing and levels of profitability we had originally anticipated. In addition, our existing point of sale system supplier has challenged the development of certain parts of our technology systems in litigation brought in the Northern District of California, case No. 20-cv-02181-MMC. We have vigorously denied the allegations made by this third-party supplier and have asserted certain counterclaims against the third party. However, the dispute regarding our ownership and involvement of certain key personnel may be costly and distracting, and the outcome is currently uncertain. Further, this litigation may delay the migration or ultimate success of our new technology.
COVID-19 may impact the operations of the Company's key suppliers, including its merchandise, personal protective equipment (PPE) and technology suppliers.
The Company depends upon the support of a small number of critical suppliers, including its merchandise, PPE and technology providers, including its third-party point of sale system supplier. We have experienced limited disruption in operations from these suppliers. The continuing impacts of the COVID-19 pandemic may pose additional disruptions in our supply chain or in the in the availability of products and services, or could increase the prices we pay to our suppliers, which could result in a material impact to our own operations.
The Company and its franchisees’ efforts to address rent obligations incurred during the government-mandated hibernation of and ongoing government-imposed operational limits placed on our salons related to the COVID-19 pandemic are ongoing and the ability to obtain long-term rent concessions is important to our future success.
The Company and its franchisees’ efforts to address rent obligations incurred during the government-mandated hibernation and ongoing government-imposed operational limits placed on our salons related to the COVID-19 pandemic are ongoing and the ability to obtain long-term rent concessions is important to our future success. While we and our franchisees have paid a significant portion of the rent due through August 2020 after giving effect to various abatement and deferral structures in place for certain lease agreements, certain of our landlords have alleged that we are in default of our leases with them. If we are unable to reach an agreement with these landlords, we or our franchisees may face eviction proceedings and/or incur costs related to litigation which could be expensive, and may jeopardize the ability to continue operations at the impacted salons and may impact our relationships with the landlords or our franchisees. The Company or franchisees also may choose from time to time to cease operations at certain salons where profitability is especially impacted by rent obligations and other challenges related to the COVID-19 pandemic. Should this occur, we may incur significant costs associated with lease terminations and winding down of operations at the affected salons if we are unable to find a replacement franchisee or determine that it is uneconomic to operate the affected salon as a company-owned business since the Company is the primary tenant on the lease for corporate and substantially all franchised salons. Whether the Company would recoup its costs from the affected franchisee for their obligations under the sublease to the Company for these locations is uncertain.
The COVID-19 pandemic has also adversely affected our franchisees ability to open organic and venditioned salons. Franchisees have delayed some openings and will likely continue to evaluate the pace and quantity of salon development, including purchasing salons from the Company, until more clarity on the post-COVID-19 operating environment emerges. Delays in organic development or the Company’s transfer of existing corporate salons to franchisees in this environment may also reduce the purchase price of such venditioned salons, the royalties and other fees received from franchisees, lead to disputes with franchisees, overall have an adverse effect on our revenues, and could result in future impairment charges, especially if the effects of the pandemic extend for a significant amount of time or grow in severity. In addition, the commercial real estate industry, including our landlords, are experiencing tenants requesting rent abatements and reductions during COVID-19, which could lead to an increase in tenant evictions and vacant spaces, landlord bankruptcies, mall and/or shopping center foreclosures, and as a result, the properties at which the Company and its franchisees operate may not be as appealing for our customers to visit and therefore cause a decrease in foot traffic and revenue at the impacted salons.
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We may face challenges operating the salons that TBG transferred back to us, and our inability to operate them successfully, close them, or transfer these salons to new ownership could adversely affect our business, financial condition, results of operations and cash flows.
On December 31, 2019, we re-acquired certain assets that were used in the operation of the mall-based salon business in the United States and Canada at which we had residual real estate lease liability from our original sale of the salons to TBG. The transfer was consummated in connection with an assignment for the benefit of creditors by TBG. The assets acquired in connection with the salon reacquisition are, in the aggregate, unprofitable and the total lease liability related to the salons is approximately $23 million as of June 30, 2020. We are attempting to renegotiate these lease obligations; however, the outcome of those negotiations is currently uncertain. In addition to the salons, we assumed limited liabilities for certain employee benefit related payments. In connection with the reacquisition of the salons, we also terminated certain other agreements we had with TBG that we had already recorded a full reserve against the promissory notes evidencing TBG’s obligations to us. As a result of our reacquisition of these salons in connection with TBG assignment for the benefit of creditors, there is a risk that a creditor of TBG could seek to void or otherwise challenge the transfer as a preference transaction. If a TBG creditor was successful in making such a claim, we could remain liable on the leases without the ability to operate the salons to generate revenue to fund the lease obligations.
While we believe the salons transferred back to us have been able to continue operations without any significant disruptions so far, except for the impacts arising out of COVID-19, these salons have experienced significant changes in recent years and, as a result, there is a risk of increased levels of employee attrition, customer losses, and supplier interruption. A loss of key personnel or material erosion of the employee base, particularly our stylists, as well as fruition of other risks could adversely affect our results of operations and could diminish the value of the salons in any future transfer of the ownership of these salons to new ownership as part of our continued commitment to converting to a fully-franchised model. If we are not able to successfully operate these salons, we may not be able to generate sufficient revenue to cover the lease liabilities for these salons. As a result, we may be compelled to close certain salons or sell the assets at depressed values. In the meantime, we expect that our operation of these salons may adversely impact our results of operations. Our inability to successfully operate the salons or transfer them to new stable ownership, could adversely affect our business, financial condition, results of operations and cash flows.
TBG’s transfer of salons in the United Kingdom to the Bushell Investment Group, which became our franchisee, is subject to review by the administrator in TBG’s insolvency proceeding in the United Kingdom.
As previously announced, we entered into a franchise agreement with the Bushell Investment Group (Bushell), which acquired over 100 salons in the United Kingdom from TBG in December 2019. The transaction occurred in connection with TBG’s insolvency proceedings in the United Kingdom. While we do not have any financial obligations in connection with the salons transferred to Bushell, the administrator in TBG’s insolvency proceeding has a legal obligation to review our original and subsequent transactions with TBG in the United Kingdom. If the administrator were to challenge our original transaction with TBG, the administrator could seek remedies to effectively unwind the economics of the original transaction or impair the ability of Bushell to continue operating these salons as our franchisee. While we do not expect the administrator to identify any concerns with our original or any subsequent transaction, any allegations against the validity of these transactions could disrupt the operation of the salons by Bushell and we could face significant adverse financial impacts or management distraction.
If we fail to comply with any of the covenants in our existing financing arrangement, we may not be able to access our existing revolving credit facility, and we may face an accelerated obligation to repay our indebtedness.
If we fail to comply with our existing financing arrangements, it may cause a default under our financing arrangement, which could limit our ability to obtain new replacement financing or additional financing under our existing credit facility, require us to pay higher levels of interest or accelerate our obligation to repay our indebtedness. We believe that the amendment of our financing arrangement in May 2020 will allow us to remain in compliance with the revised covenants notwithstanding the impacts to our business of converting to a fully-franchised model and other impacts arising out of COVID-19; however, significant and continued business disruptions could ultimately impair our ability to comply with the new liquidity covenant, which could preclude our ability to access our credit facility or accelerate our debt repayment obligation, which is now secured by a lien on substantially all of the Company's assets.
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It is important for us and our franchisees to attract, train and retain talented stylists and salon leaders.
Guest loyalty is dependent upon the stylists who serve our guests and the customer experience in our franchised and company-owned salons. Qualified, trained stylists are key to a memorable guest experience that creates loyal customers. In order to profitably grow our business, it is important for our franchisees and company-owned salons to attract, train and retain talented stylists and salon leaders and to adequately staff our salons. Because the salon industry is highly fragmented and comprised of many independent operators, the market for stylists is typically highly competitive. In addition, increases in minimum wage requirements may impact the number of stylists considering careers outside the beauty industry. 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 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. In addition, we have observed that some stylists are not comfortable coming back to the salon environment during COVID-19 and the enhanced unemployment amounts provided by the federal government during COVID-19 in some cases decreases stylists' incentive to come back to work during COVID-19. 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.
Our continued success depends in part on the success of our franchisees, which operate independently.
As of June 30, 2020, approximately 76.1% of our salons were franchised locations, and we continue to pursue conversion to a fully-franchised model. We derive revenues associated with our franchised locations from royalties, fees and product sales to franchised locations. Our financial results are therefore substantially dependent upon the operational and financial success of our franchisees. As we increase our focus on our franchise business, our dependence on our franchisees grows.
We have limited control over how our franchisees’ businesses are run. Though we have established operational standards and guidelines, they own, operate and oversee the daily operations of their salon locations including employee-related matters and pricing. If franchisees do not successfully operate their salons in compliance with our standards, our brand reputation and image could be harmed, and our financial results could be affected. We could experience greater risks as the scale of our franchise owners increases. Further, some franchise owners may not successfully execute the rebranding and/or turnaround of under-performing salons which we have transferred to them particularly in the post-COVID environment.
In addition, our franchisees are subject to the same general economic risks as our Company, and their results are influenced by competition for both guests and stylists, market trends, price competition and disruptions in their markets and business operations due to public health issues, including pandemics, severe weather and other external events. Like us, they rely on external vendors for some critical functions and to protect their company data. They may also be limited in their ability to open new locations by an inability to secure adequate financing, especially since many of them are small businesses with much more limited access to financing than our Company, or by the limited supply of favorable real estate for new salon locations, or by government-mandated restrictions on salon operations due to COVID-19 or other pandemics. They may also experience financial distress as a result of over-leveraging, which could negatively affect our operating results as a result of delayed or non-payments to us. The bankruptcy, default, abandonment, or other default or breach by or of a franchisee could also expose us to liability under leases, which are generally sub-leased by us to our franchisees.
A deterioration in the financial results of our franchisees, or a failure of our franchisees to renew their franchise agreements, could adversely affect our operating results through decreased royalty payments, fees and product revenues.
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The sale of company-owned salons to franchisees may not improve our operating results and could cause operational difficulties.
In August 2019, the Company announced our plan to convert to a fully-franchised platform over time. While we have had significant success in converting our salons to franchisees, our continued success will depend on a number of factors, including franchisees’ ability to improve the results of the salons they purchase, their ability and interest in continuing to grow their business, and their willingness to purchase salons during the COVID-19 pandemic and government-imposed closure and operational limitations. We also must continue to attract qualified franchisees and work with them to make their business successful. Moving a salon from company-owned to franchise-owned is expected to reduce our consolidated revenues, increase our royalty revenue and decrease our operating costs; however, the actual benefit from a sale is uncertain and may be insufficient to offset the loss of revenues. Also, our gross margins on wholesale product sales are lower than our gross margins on retail product sales. Furthermore, the timing of decreasing operating costs may significantly lag the transfer to franchisees, because it takes time to reduce the general and administrative costs directly or indirectly associated with a transferred salon.
In addition, challenges in supporting our expanding franchise system could cause our operating results to suffer. If we are unable to effectively select and train new franchisees and support our growing franchisee base, it could affect our brand standards, cause disputes between us and our franchisees, and potentially lead to material liabilities.
If our capital investments in developing new technology-enabled capabilities and improving current technology infrastructure do not achieve appropriate returns, our financial condition and results of operations may be adversely affected.
We are currently making, and expect to continue to make, strategic investments in technology to improve guest experiences and improve our back-office systems, including, without limitation, our OpenSalon mobile application and platform that we launched in 2019 and our OpenSalon Pro salon management system that we launched in August 2020. These investments might not provide the anticipated benefits or desired return and could expose us to additional legal and compliance risks. Furthermore, some of the Company’s technology capabilities and developments involve third party partnerships, on which we are dependent. If these partnerships are not successful, the capabilities may not fully achieve their anticipated returns. In addition, if we are unable to successfully protect any intellectual property rights resulting from our investments, the value received from those investments may be eroded, which could adversely affect our financial condition. Among other things, targeting the wrong investment opportunities, failing to successfully meet our strategic objectives when making the correct investments, being unable to make new concepts scalable or achieving appropriate market or franchisee adoption, and/or making an investment commitment significantly above or below our needs could adversely affect our financial condition and results of operations. Further, our existing third-party back office salon management supplier may try to make our franchisees' transition to OpenSalon Pro difficult or costly, which could cause our anticipated benefits or desired returns from our new back office salon management technology to decrease.
Cybersecurity incidents could result in the compromise of potentially sensitive information about our guests, franchisees, employees, vendors or company and expose us to business disruption, negative publicity, costly government enforcement actions or private litigation and our reputation could suffer.
The normal operations of our business and our new investments in technology involve processing, transmission and storage of potentially personal information about our guests as well as employees, franchisees, vendors and our Company. Cyber-attacks designed to gain access to sensitive information by breaching mission critical systems of large organizations and their third-party vendors are constantly evolving, and high profile electronic security breaches leading to unauthorized release of sensitive guest information have occurred at a number of large U.S. companies in recent years. Despite the security measures and processes we have in place, our efforts, and those of our third-party vendors, to protect sensitive guest, franchisee, Company and employee information may not be successful in preventing a breach in our systems or detecting and responding to a breach on a timely basis. As a result of a security incident or breach in our systems, our systems could be interrupted or damaged, or sensitive information could be accessed by third parties. If that occurred, our guests could lose confidence in our ability to protect their information, which could cause them to stop visiting our salons altogether or our franchisees could exit the system due to lack of confidence as well. Such events could lead to lost future sales and adversely affect our results of operations. In addition, as the regulatory environment relating to retailers and other companies' obligations to protect sensitive data becomes stricter, a material failure on our part to comply with applicable regulations could subject us to fines or other regulatory sanctions and potentially to lawsuits with the possibility of substantial damages. These laws are changing rapidly and vary among jurisdictions. Furthermore, while our franchisees are independently responsible for data security at their franchised locations, a breach of guest or vendor data at a franchised location could also negatively affect public perception of our brands. More broadly, our incident response preparedness and disaster recovery planning efforts may be inadequate or ill-suited for a security incident and we could suffer disruption of operations or adverse effects to our operating results.
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Our ability to franchise our company-owned SmartStyle salons and successfully operate this business is dependent on our relationship with Walmart.
At June 30, 2020, we had 2,068 SmartStyle or Cost Cutters salons within Walmart locations, including 4 salons opened during fiscal year 2020 (net of relocations). Walmart is our largest landlord, and we believe we are Walmart’s largest tenant. Our business within each of those 2,068 salons relies primarily on the traffic of visitors to the Walmart in which it is located, so our success is tied to Walmart’s success in bringing shoppers into their stores. We have limited control over the locations and markets in which we open new SmartStyle locations, as we only have potential opportunities in locations offered to us by Walmart. Furthermore, Walmart has the right to close up to 100 of our salons per year for any reason, upon payment of certain penalties; to terminate lease agreements for breach, such as if we failed to conform with required operating hours, subject to a notice and cure period; and to terminate the lease if the Walmart store in which it sits is closed. Furthermore, in an effort to manage traffic flow and direction during COVID-19, Walmart has elected at some stores to close one or more of its primary entryways. We have found that when the entry way nearest to our salon is closed, foot traffic in the salon is materially reduced. We are currently discussing this issue and other issues related to COVID-19 with Walmart, but there is no assurance they will be resolved. In fiscal year 2017, we began franchising select SmartStyle branded locations. Future franchising activity will require and be limited by the approval of Walmart on a location by location basis. Walmart may not give their approval to franchise some or all of our company-owned salons. Further, Walmart may attempt to impose changes to the terms and conditions of our agreements which are contrary to our economic interests. Operating both company-owned and franchised SmartStyle salons adds complexity in overseeing franchise compliance and coordination with Walmart.
Recent actions by Walmart have materially impacted our SmartStyle franchise operations.
In the fourth fiscal quarter of 2020, Walmart issued a mandatory mask requirement for customers who visit their U.S. store operations. In order to enforce this requirement, Walmart has closed several entrances to its stores including entrances at the front of their brick and mortar locations where many of our SmartStyle and Cost Cutters salons are located. Although we appreciate and support Walmart’s national effort to require the use of masks by their customers their decision to close entrances located near our salons has materially reduced customer traffic and salon revenues in both our franchise and company-owned operations. We have addressed these issues directly with Walmart and are hopeful that this will prove to be a temporary policy. However, we cannot be certain when or if Walmart will reopen their store entrances. As a result, this could lead to further deterioration in, or subsequent closures of, our SmartStyle or Cost Cutters brands during the period of the pandemic or as long as Walmart continues to close these entrances or potentially expose Regis to litigation, sublease rent default exposure, or could compel the Company to pursue certain other remedies from Walmart up to or including litigation and/or termination of certain locations.
Our future growth and profitability may depend, in part, on our ability to build awareness and drive traffic with advertising and marketing efforts, and on delivering a quality guest experience to drive repeat visits to our salons.
Our future growth and profitability may depend on the effectiveness, efficiency and spending levels of our marketing and advertising efforts to drive awareness and traffic to our salons. In addition, delivering a quality guest experience is crucial in order to drive repeat visits to our salons. We are developing our marketing and advertising strategies, including national and local campaigns, to build awareness, drive interest, consideration and traffic to our salons. We are also focusing on improving guest experiences to provide brand differentiation and preference, and to ensure we meet our guests’ needs. If our marketing, advertising and improved guest experience efforts do not generate sufficient customer traffic and repeat visits to our salons, our business, financial condition and results of operations may be adversely affected.
Changes in regulatory and statutory laws, such as increases in the minimum wage and changes that make collective bargaining easier, and the costs of compliance and non-compliance with such laws, may result in increased costs to our business.
With 6,923 locations and approximately 9,000 employees worldwide, our financial results can be adversely impacted by regulatory or statutory changes in laws. Due to the number of people we or our franchisees employ, laws that increase minimum wage rates, employment taxes, overtime requirements or costs to provide employee benefits or administration may result in additional costs to our Company.
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A number of U.S. states, Canadian provinces and municipalities in which we do business have recently increased or are considering increasing the minimum wage, with increases generally phased over several years depending upon the size of the employer. Increases in minimum wages and overtime pay increase our costs, and our ability to offset these increases through price increases may be limited. In fact, increases in minimum wages increased our costs over the last five years. In addition, a growing number of states, provinces, and municipalities have passed or are considering requirements for paid sick leave, family leave, predictive scheduling (which imposes penalties for changing an employee’s shift as it nears), and other requirements that increase the administrative complexity of managing our workforce. Finally, changes in labor laws, such as recent legislation in Ontario and Alberta designed to facilitate union organizing, could increase the likelihood of some of our employees being subjected to greater organized labor influence. If a significant portion of our employees were to become unionized, it would have an adverse effect on our business and financial results.
Increases in minimum wages, administrative requirements and unionization could also have an adverse effect on the performance of our franchisees, especially if our franchisees are treated as a "joint employer" with us by the National Labor Relations Board (NLRB) or as a large employer under minimum wage statutes because of their affiliation with us. In addition, we must comply with state employment laws, including the California Labor Code, which has stringent requirements and penalties for non-compliance.
Various state and federal laws govern our relationship with our franchisees and our potential sale of a franchise. If we fail to comply with these laws, we could be liable for damages to franchisees and fines or other penalties. A franchisee or government agency may bring legal action against us based on the franchisee/franchisor relationship. Also, under the franchise business model, we may face claims and liabilities based on vicarious liability, joint-employer liability, or other theories or liabilities. All such legal actions not only could result in changes to laws and interpretations, making it more difficult to appropriately support our franchisees and, consequently, impacting our performance, but, also, such legal actions could result in expensive litigation with our franchisees, third parties or government agencies that could adversely affect both our profits and our important relations with our franchisees. In addition, other regulatory or legal developments may result in changes to laws or the franchisee/franchisor relationship that could negatively impact the franchise business model and, accordingly, our profits.
In addition to employment and franchise laws, we are also subject to a wide range of federal, state, provincial and local laws and regulations, including those affecting public companies, product manufacture and sale, and governing the franchisee/franchisor relationship, in the jurisdictions in which we operate. Compliance with new, complex and changing laws may cause our expenses to increase. In addition, any non-compliance with laws or regulations could result in penalties, fines, product recalls and enforcement actions or otherwise restrict our ability to market certain products or attract or retain employees, which could adversely affect our business, financial condition and results of operations.
Our success depends substantially on the value of our brands.
Our success depends, in large part, on our ability to maintain and enhance the value of our brands, our customers’ connection to our brands, and a positive relationship with our franchisees. Brand value can be severely damaged even by isolated incidents, particularly if the incidents receive considerable negative publicity, including via social media, or result in litigation. Some of these incidents may relate to the way we manage our relationship with our franchisees, our growth strategies, our development efforts, or the ordinary course of our, or our franchisees’, business. Other incidents may arise from events that may be beyond our control and may damage our brands, such as actions taken (or not taken) by one or more franchisees or their employees relating to health, safety, welfare, or otherwise; litigation and claims; security breaches or other fraudulent activities associated with our back office management or payment systems; and illegal activity targeted at us or others. Consumer demand for our products and services and our brands’ value could diminish significantly if any such incidents or other matters erode consumer confidence in us or our products or services, which could result in lower sales and, ultimately, lower royalty income, and in turn could materially and adversely affect our business and operating results.
Premature termination of franchise agreements can cause losses.
Our franchise agreements may be subject to premature termination in certain circumstances, such as failure of a franchisee to cure a default, monetary or otherwise, a franchisee bankruptcy, or abandonment of the franchise. If terminations occur for these or other reasons, we may need to enforce our right to damages for breach of contract and related claims, which could cause us to incur significant legal fees and expenses and/or to take back and operate such salons as company-owned. Any damages we ultimately collect could be less than the projected future value of the fees and other amounts we would have otherwise collected under the franchise agreement. In addition, with many of our brands, we remain liable under the lease and, therefore, will be obligated to pay rent or enter into a settlement with the landlord, and we may not be made whole by the franchisee. A significant loss of franchisee agreements due to premature terminations could hurt our financial performance or our ability to grow our business.
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We rely heavily on our information technology systems for our key business processes. If we experience an interruption in their operation, our results of operations may be affected.
The efficient operation of our business is dependent on our management information systems. We rely heavily on our management information systems to collect daily sales information and guest demographics, generate payroll information, monitor salon performance, manage salon staffing and payroll costs, manage our two distribution centers and other inventory and other functions. Such systems are subject to damage or interruption from power outages, computer and telecommunications failures, computer viruses, hackers, security breaches, and natural disasters. In addition, certain of our management information systems are currently developed and maintained by external vendors, including our back office salon management system, and some are outdated or of limited functionality, not owned by the Company or not exclusively provided by the Company. The failure of our management information systems to perform as we anticipate, meet the continuously evolving needs of our business, or provide an affordable long-term solution, could disrupt our business operations and result in other negative consequences, including remediation costs, loss of revenue, and reputational damage. These external vendors' conduct with respect to our franchisees could also result in litigation.
We rely on external vendors for products and services critical to our operations.
We rely on external vendors for the manufacture of our owned brand products, other retail products we sell, and products we use during salon services such as color and chemical treatments. We also rely on external vendors for various services critical to our operations and the security of certain Company data. Our dependence on vendors exposes us to operational, reputational, financial, and compliance risk.
If our product offerings do not meet our guests’ expectations regarding safety and quality, we could experience lost sales, increased costs, and exposure to legal and reputational risk. All of our vendors must comply with applicable product safety laws, and we are dependent on them to ensure that the products and packages we buy, for either use on a guest during a service or resale to the public, comply with all safety and quality standards. Events that give rise to actual, potential, or perceived product safety concerns or mislabeling could expose us to government enforcement action and/or private litigation and result in costly product recalls and other liabilities.
Our vendors are also responsible for the security of certain Company data, as discussed above. In the event that one of our key vendors becomes unable to continue to provide products and services, or their systems fail, are compromised or the quality of their systems deteriorate, we may suffer operational difficulties and financial loss.
Consumer shopping trends and changes in manufacturer choice of distribution channels may negatively affect both service and product revenues.
Both our franchised and company-owned salons are partly dependent on the volume of traffic around their locations in order to generate both service and product revenues. Supercuts salons and most of our other brands are located mainly in strip center locations, which have been significantly impacted by landlord closures due to COVID-19, and SmartStyle salons are located within Walmart Supercenters, so they are especially sensitive to Walmart traffic. Customer traffic may be adversely affected by changing consumer shopping trends that favor alternative shopping locations, such as the internet. In recent years, we have experienced substantial declines in traffic in some shopping malls in particular and traffic patterns at those salons affect our potential product sales revenues and impact the health of our brands.
In addition, we are experiencing a proliferation of alternative channels of distribution, like blow dry bars, booth rental facilities, discount brick-and-mortar and online professional products retailers, and manufacturers selling direct to consumers online, which may negatively affect our product and service revenue. Also, product manufacturers may decide to utilize these other distribution channels to a larger extent than in the past and they generally have the right to terminate relationships with us with little advance notice. These trends could reduce the volume of traffic around our salons, and in turn, our revenues may be adversely affected.
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If we are not able to successfully compete in our business markets, our financial results may be affected.
Competition on a market by market basis remains challenging as many smaller chain competitors are franchise systems with local operating strength in certain markets and the hair salon industry as a whole is fragmented and highly competitive for customers, stylists and prime locations. Therefore, our ability to attract guests, raise prices and secure suitable locations in certain markets can be adversely impacted by this competition. Our strategies for competing are complicated by the fact that we have multiple brands in multiple segments, which compete on different factors.
We also face significant competition for prime real estate, particularly in strip malls. We compete for lease locations not only with other hair salons, but with a wide variety of businesses looking for similar square footage and high-quality locations.
Furthermore, our reputation is critical to our ability to compete and succeed. Our reputation may be damaged by negative publicity on social media or other channels regarding the quality of products or services we provide. There has been a substantial increase in the use of social media platforms, which allow individuals to be heard by a broad audience of consumers and other interested persons. Negative or false commentary regarding us or the products or services we offer may be posted on social media platforms at any time. Customers value readily available information and may act on information without further investigation or regard to its accuracy. The harm to our reputation may be immediate, without affording us an opportunity for redress or correction. Our reputation may also be damaged by factors that are mostly or entirely out of our control, including actions by a franchisee or a franchisee’s employee. If we are not able to successfully compete, our ability to grow same-store sales and increase our revenue and earnings may be impaired.
If we fail to maintain an effective system of internal controls over financial reporting, we may not be able to accurately report our financial results and prevent or detect material misstatement due to fraud, which could reduce investor confidence and adversely affect the value of our common stock.
Effective internal controls over financial reporting are necessary for us to provide reliable financial reports and effectively prevent and detect material fraud. If we cannot provide reliable financial reports or prevent or detect material fraud, our operating results could be materially misstated. We identified an error in our quarterly financial statements related to the derecognition of goodwill associated with company-owned salons that were sold in the quarter ended December 31, 2019 that resulted in a revision to our financial statements for that quarter. As a result, we concluded that a material weakness in our internal control over the accounting for non-cash goodwill derecognition existed until the end of the quarter ended March 31, 2020, at which time the conditions causing the material weakness no longer existed and are not expected to exist. There can be no assurances that we will be able to prevent future control deficiencies from occurring, which could cause us to incur unforeseen costs, reduce investor confidence, cause the market price of our common stock to decline or have other potential adverse consequences.
We could be subject to changes in tax rates, the adoption of new U.S. or international tax legislation or exposure to additional tax liabilities.
We are subject to income taxes in the U.S. and other foreign jurisdictions. Significant judgment is required in determining our tax provision for income taxes. In the ordinary course of our business, there are many transactions and calculations where the ultimate tax determination is uncertain. We are subject to the examination of our income tax returns, payroll taxes and other tax matters by the Internal Revenue Service and other tax authorities and governmental bodies. The Company regularly assesses the likelihood of an adverse outcome resulting from these examinations to determine the adequacy of its provision for income taxes and payroll tax accruals. There can be no assurances as to the outcome of these examinations. Although we believe our tax estimates are reasonable, the final determination of tax audits and any related litigation could be materially different from our historical tax provisions and employment taxes. The results of an audit or litigation could have a material effect on our Consolidated Financial Statements in the period or periods for which that determination is made.
Our effective income tax rate in the future could be adversely affected by a number of factors, including changes in the mix of earnings in countries with different statutory tax rates, changes in tax laws, or the outcome of income examinations.
Failure to simplify and standardize our operating processes across our brands could have a negative impact on our financial results.
We expect standardization of operating processes across our brands, marketing and products to enable us to simplify our operating model and decrease our costs and believe failure to do so could adversely impact our ability to grow revenue and realize further efficiencies within our results of operations.
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Empire Education Group may be unsuccessful which could adversely affect our financial results.
In 2020, we entered into an agreement to sell our 55% ownership stake in Empire Education Group (EEG), an operator of accredited cosmetology schools to the other owner. The transaction is subject to regulatory approval before it can close, and there is no guarantee that the regulatory approval will occur, which has been delayed in part due to COVID-19. Due to poor financial performance, we fully impaired the investment in prior years. If the transaction does not close as anticipated and EEG is unsuccessful in executing its business plan, or if economic, regulatory and other factors, including declines in enrollment, revenue and profitability continue for the for-profit secondary education market, our financial results may be affected by certain potential liabilities related to this investment. The transaction is expected to close in fiscal year 2021, at which time the Company expects to record an immaterial non-operating gain.
Failure to control costs may adversely affect our operating results.
We must continue to control our expense structure. Failure to manage our cost of product, labor and benefit rates, advertising and marketing expenses, operating lease costs, other store expenses or indirect spending could delay or prevent us from achieving increased profitability or otherwise adversely affect our operating results.
Changes in the general economic environment may impact our business and results of operations.
Changes to the U.S., Canadian and United Kingdom economies have an impact on our business. General economic factors that are beyond our control, such as recession, inflation, deflation, tax rates and policy, energy costs, unemployment trends, extreme weather patterns, viruses, pandemics, stay-at-home orders and other casualty events that influence consumer confidence and spending, may impact our business. In particular, visitation patterns to our salons can be adversely impacted by increases in unemployment rates and decreases in discretionary income levels.
Changes in consumer tastes, hair product innovation, fashion trends and consumer spending patterns may impact our revenue.
Our success depends in part on our ability to anticipate, gauge and react in a timely manner to changes in consumer tastes, hair product innovation, fashion trends and consumer spending patterns. If we do not timely identify and properly respond to evolving trends and changing consumer demands for hair care, our sales may decline. Furthermore, we may accumulate additional inventory and be required to mark down unsold inventory to prices that are lower than normal prices, which could adversely impact our margins and could further adversely impact our business, financial condition and results of operations.
Operational failure at one of our distribution centers would impact our ability to distribute products.
We operate two distribution centers, one near Chattanooga, Tennessee, and one near Salt Lake City, Utah. These supply our North America company-owned salons and many of our franchisees with retail products to sell and products used during salon services. They also provide 3PL services for other third-party manufacturers for a profit. If there were a technology failure, natural disaster or other catastrophic event that caused one of the distribution centers to be inoperable, it would cause a disruption in our business and could negatively impact our revenues.
Our enterprise risk management program may leave us exposed to unidentified or unanticipated risks.
We maintain an enterprise risk management program that is designed to identify, assess, mitigate, and monitor the risks that we face. There can be no assurance that our frameworks or models for assessing and managing known risks, compliance with applicable law, and related controls will effectively mitigate risk and limit losses in all market environments or against all types of risk in our business. If conditions or circumstances arise that expose flaws or gaps in our risk management or compliance programs, the performance and value of our business could be adversely affected.
Insurance and other traditional risk-shifting tools may be held by or available to the Company in order to manage certain types of risks, but they are subject to terms such as deductibles, retentions, limits and policy exclusions, as well as risk of denial of coverage, default or insolvency. If we suffer unexpected or uncovered losses, or if any of our insurance policies or programs are terminated for any reason or are not effective in mitigating our risks, we may incur losses that are not covered or that exceed our coverage limits and could adversely impact our results of operations, cash flows and financial position.
The franchise arrangements require each franchisee to maintain certain insurance coverages and levels. Certain extraordinary hazards, however, may not be covered, and insurance may not be available (or may be available only at prohibitively expensive rates) with respect to many other risks. Moreover, any loss incurred could exceed policy limits and policy payments made to franchisees may not be made on a timely basis. Any such loss or delay in payment could have a material and adverse effect on a franchisee’s ability to satisfy its obligations under its franchise arrangement, including its ability to make royalty payments.
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We rely on our management team and other key personnel.
We depend on the skills, working relationships, and continued services of key personnel, including our management team and others throughout our organization. We are also dependent on our ability to attract and retain qualified personnel, for whom we compete with other companies both inside and outside our industry. Our business, financial condition or results of operations may be adversely impacted by the unexpected loss of any of our management team or other key personnel, or more generally if we fail to identify, recruit, train and/or retain talented personnel. Additionally, the Chief Executive Officer's employment agreement may end before the Company's multi-year strategic transformation is complete, or before the impact of the pandemic has been stabilized. Further, any successor candidate, no matter how well-qualified, may not be successful in a post-COVID environment.
Item 1B. Unresolved Staff Comments
None.
Item 2. Properties
In December 2019, the Company sold the corporate office consisting of a 139,000 square foot, two building complex in Edina, Minnesota that was owned by the Company. In March 2019, the Company signed a ten-year lease for a new corporate headquarters in Minneapolis, Minnesota, with the move to the new headquarters completed in April 2020.
The Company also operates offices in Toronto, Canada and Fremont, CA under long-term leases.
In fiscal year 2019, the Company sold its distribution centers located in Chattanooga, Tennessee and Salt Lake City, Utah and signed long-term leases to continue to operate in the locations. The Chattanooga facility utilizes 230,000 square feet while the Salt Lake City facility utilizes 210,000 square feet.
The Company also leases the premises in which approximately 92% of our franchisees operate and has entered into corresponding sublease arrangements with the franchisees. Generally, these leases have a five year initial term and one or more five-year renewal options. All lease costs are passed through to the franchisees. Remaining franchisees who do not enter into sublease arrangements with the Company negotiate and enter into leases on their own behalf.
The Company operates all of its salon company-owned locations under leases or license agreements. Salons operating within strip centers, malls and Walmart Supercenters have leases with original terms of at least five years, generally with the ability to renew, at the Company's option, for one or more additional five year periods. Salons operating within department stores in Canada operate under license agreements, while freestanding or shopping center locations have real property leases comparable to the Company's company-owned locations.
None of the Company's salon leases are individually material to the operations of the Company, and the Company expects that it will be able to renew its leases on satisfactory terms as they expire or identify and secure other suitable locations. See Note 6 to the Consolidated Financial Statements in Part II, Item 8, of this Form 10-K.
Item 3. 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 consumer and wage and hour violations. Litigation is inherently unpredictable and the outcome of these matters cannot presently be determined. Although the actions are being vigorously defended, the Company 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 4. Mine Safety Disclosures
Not applicable.
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PART II
Item 5. Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Repurchase of Equity Securities
Regis common stock is listed and traded on the New York Stock Exchange under the symbol "RGS."
As of August 14, 2020, Regis had approximately 1,200 shareholders of record. The closing stock price was $9.31 per share on August 14, 2020.
In accordance with its capital allocation policy, the Company does not pay dividends.
The following graph compares the cumulative total shareholder return on the Company's stock for the last five years with the cumulative total return of the Standard and Poor's 500 Stock Index and the cumulative total return of a peer group index (the Peer Group) constructed by the Company. In addition, the Company has included the Standard and Poor's 400 Midcap Index and the Dow Jones Consumer Services Index in this analysis because the Company believes these two indices provide a comparative correlation to the cumulative total return of an investment in shares of Regis Corporation.
The Peer Group consists of the following companies: Boyd Gaming Corp., Brinker International, Inc., Cracker Barrel Old Country Store, DineEquity, Inc., Fossil Group, Inc., Fred's, Inc., Jack in the Box, Inc., Penn National Gaming, Inc., Revlon, Inc., Sally Beauty Holdings, Inc., Service Corporation International, The Cheesecake Factory, Inc. and Ulta Salon, Cosmetics & Fragrance Inc. The Peer Group is a self-constructed peer group of companies that have comparable annual revenues and market capitalization and are in the beauty industry or other industries where guest service, multi-unit expansion or franchise play a part. Information regarding executive compensation will be set forth in the 2020 Proxy Statement.
The comparison assumes the initial investment of $100 in the Company's common stock, the S&P 500 Index, the Peer Group, the S&P 400 Midcap Index and the Dow Jones Consumer Services Index on June 30, 2015 and that dividends, if any, were reinvested.
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Comparison of 5 Year Cumulative Total Return
Assumes Initial Investment of $100
June 30, 2020
In May 2000, the Company's Board of Directors (Board) approved a stock repurchase program with no stated expiration date. Since that time and through June 30, 2020, the Board has authorized $650.0 million to be expended for the repurchase of the Company's stock under this program. All repurchased shares become authorized but unissued shares of the Company. The timing and amounts of any repurchases depends on many factors, including the market price of the common stock and overall market conditions. As of June 30, 2020, 30.0 million shares have been cumulatively repurchased for $595.4 million, and $54.6 million shares remained outstanding under the approved stock repurchase program.
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The Company repurchased the following common stock through its share repurchase program:
Fiscal Years
The following table shows the stock repurchase activity by the Company or any “affiliated purchaser” of the Company, as defined in Rule 10b-18(a)(3) under the Exchange Act, by month for the three months ended June 30, 2020:
Item 6. Selected Financial Data
Beginning with the period ended September 30, 2017, the operations of the mall-based business and International segment were accounted for as a discontinued operation. All periods presented reflect the mall-based business and International segment as a discontinued operation.
The following table sets forth selected financial data derived from the Company's Consolidated Financial Statements in Part II, Item 8 of this Form 10-K. The table should be read in conjunction with Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations" and Item 8, "Financial Statements and Supplementary Data" of this Form 10-K.
Fiscal Years
(Dollars in thousands, except per share data)
(Dollars in thousands)
_______________________________________________________________________________
(1)The following significant items affected each of the years presented:
•During fiscal year 2020, the Company recorded a $40.2 million non-cash goodwill impairment charge, a $22.6 million non-cash long-lived asset impairment charge (See Note 1 to the Consolidated Financial Statements in Part II, Item 8, of this form 10-K), a loss on the sale of salons to franchisees of $27.3 million and the results were materially impacted by the COVID-19 pandemic.
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•During fiscal year 2019, the Company recorded a $21.8 million restructuring charge related to TBG mall locations (See Note 3 to the Consolidated Financial Statements in Part II, Item 8, of this form 10-K), $4.6 million of non-cash fixed asset impairment charges and $2.9 million of net gain on salons sold to franchisees.
•During fiscal year 2018, the Company recorded a $68.1 million income tax benefit resulting from the federal rate reduction and a partial release of the U.S. valuation allowance as a result of the Tax Cuts and Jobs Act (the “Tax Act”), $41.2 million ($32.5 million, net of taxes) of expenses associated with the January 2018 SmartStyle portfolio restructure and other related costs, $11.1 million of non-cash fixed asset impairment charges, $8.0 million of gain on company-owned life insurance policies, and $2.7 million ($2.2 million, net of taxes) of severance expense related to terminations.
•During fiscal year 2017, the Company recorded $7.9 million of non-cash fixed asset impairment charges, $8.4 million of severance expense related to the termination of former executive officers including the Company's Chief Executive Officer, $7.7 million of non-cash tax expense related to tax benefits on certain indefinite-lived assets that the Company cannot recognize for reporting purposes and $5.3 million of expense for a one-time non-cash inventory expense related to salon tools.
•During fiscal year 2016, the Company recorded a $13.0 million other than temporary non-cash impairment charge to fully impair its investment in EEG, $10.5 million of non-cash fixed asset impairment charges and $7.9 million of non-cash tax expense related to tax benefits on certain indefinite-lived assets that the Company cannot recognize for reporting purposes.
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
Management's Discussion and Analysis of Financial Condition and Results of Operations (MD&A) is designed to provide a reader of our financial statements with a narrative from the perspective of our management on our financial condition, results of operations, liquidity and certain other factors that may affect our future results.
BUSINESS DESCRIPTION
Regis Corporation (RGS) franchises, owns and operates beauty salons. As of June 30, 2020, the Company franchised, owned or held ownership interests in 6,923 worldwide locations. Our locations consisted of 6,841 system-wide North American and International salons, and in 82 locations we maintain a non-controlling ownership interest less than 100 percent. Each of the Company’s salon concepts generally offer similar salon products and services. As of June 30, 2020, we had approximately 9,000 corporate employees worldwide. See discussion within Part I, Item 1.
In October 2017, the Company sold substantially all of its mall-based salon business in North America, representing 858 company-owned salons, and substantially all of its International segment, representing approximately 250 company-owned salons, to TBG. In the second quarter of fiscal year 2020, TBG transferred 207 of its North American salons to the Company. See Note 3 to the Consolidated Financial Statements in Part II, Item 8, of this Form 10-K, as the results of operations for the mall-based business and International segment are accounted for as a discontinued operation for all periods presented.
In January 2018, the Company closed 597 non-performing company-owned SmartStyle salons. The 597 non-performing salons generated negative cash flow of approximately $15 million during the twelve months ended September 30, 2017. The action delivers on the Company's commitment to restructure its salon portfolio to improve shareholder value and position the Company for long-term growth. A summary of costs associated with the SmartStyle salon restructuring for fiscal year 2018 is as follows:
Financial Line Item Fiscal Year 2018
(Dollars in thousands)
Inventory reserves Cost of Service $ 656
Inventory reserves Cost of Product 586
Severance General and administrative 897
Long-lived fixed asset impairment Depreciation and amortization 5,460
Asset retirement obligation Depreciation and amortization 7,680
Lease termination and other related closure costs Rent 27,290
Deferred rent Rent (3,291)
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In addition, the Company recorded approximately $1.9 million of other related costs to the SmartStyle restructuring, primarily warehouse related costs. Substantially all related costs associated with the SmartStyle salon restructuring requiring cash outflow were complete as of June 30, 2018.
As part of the Company's strategic transition to a fully-franchised model, the Company is selling salons to franchisees. The impact of these transactions are as follows:
Fiscal Years Increase (Decrease)
(Dollars in thousands)
____________________________________________________________________________
(1) Fiscal year 2018 includes the mall salons transferred to The Beautiful Group for no proceeds.
RESULTS OF OPERATIONS
The Company reports its operations in two operating segments: Franchise salons and Company-owned salons, effective October 2017. The Company's operating segments are its reportable operating segments. Prior to this change, the Company had four operating segments: North American Value, North American Premium, North American Franchise and International.
Beginning with the period ended September 30, 2017, the mall-based business and International segment were accounted for as discontinued operations for all periods presented. Discontinued operations are discussed at the end of this section. See Note 3 to the Consolidated Financial Statements in Part II, Item 8, of this Form 10-K for further discussion on this transaction.
The Company realigned its field leadership team beginning in the first quarter of fiscal year 2018. An outcome of this reorganization is that the costs associated with senior district leaders were moved out of cost of goods sold and site operating expense and into G&A. This change affected one month of comparability during the fiscal year ended June 30, 2018. The estimated impact of the field reorganization (decreased) increased Cost of Service, Site Operating expense and General and Administrative expense by $(2.4), $(0.4) and $2.8 million, respectively, for fiscal year 2018. This expense classification does not have a financial impact on the Company's reported operating loss, reported net (loss) income or cash flows from operations.
COVID-19 Impact:
During the second half of fiscal year 2020, the global coronavirus pandemic (COVID-19) had an adverse impact on our operations, including the closure of all company-owned salons and almost all franchise locations from March 2020 due to government mandates. Salons continued to be closed until April 23, 2020 when franchise salons began re-opening slowly, as government, state and local restrictions eased. As of June 30, 2020, approximately 87% of franchise salons were open. Company-owned salons were closed through May 21, 2020 and are gradually re-opening. As of June 30, 2020, approximately 54% of company-owned salons were open. As salons re-open, the Company is taking additional measures across its portfolio of franchise and company-owned salons to facilitate customer and employee safety. As a result, COVID-19 has and will continue to negatively affect revenue and profitability. To offset the loss of revenue, in April 2020, we implemented a furlough program for a majority of the workforce across the corporate office, field support, and distribution centers; and reductions in the pay for executives and other working employees. The furlough program was in effect for the majority of the fiscal fourth quarter. Despite actions taken to resume business operations, COVID-19, and the volatile regional and global economic conditions stemming from the pandemic, as well as reactions to future pandemics or resurgences of COVID-19, could potentially prolong and intensify the impact of the global crisis on our business.
The economic disruption due to COVID-19 was determined to be a triggering event and as a result, management assessed its long-term assets, including long-lived salon assets, right of use assets, goodwill and other intangibles for impairment. See Note 1 to the Consolidated Financial Statements in Part II, Item 8, of this Form 10-K for further discussion on the pandemic.
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System-wide results
As we transition to an asset-light franchise platform, our results will be more impacted by our system-wide sales, which include sales by all points of distribution, whether owned by the Company or our franchisees. While we do not record sales by franchisees as revenue, and such sales are not included in our Consolidated Financial Statements, we believe that this operating measure is important in obtaining an understanding of our financial performance. We believe system-wide sales information aids in understanding how we derive royalty revenue and in evaluating performance.
System-wide same-store sales (1) by concept are detailed in the table below:
Fiscal Years
SmartStyle (5.5) % 1.0 % (0.2) %
Signature Style (3.7) (0.8) 0.5
Total, excluding TBG mall-locations N/A (0.1) N/A
TBG mall-locations N/A (4.5) N/A
____________________________________________________________________________
(1)System-wide same-store sales are calculated as the total change in sales for system-wide franchise and company-owned locations for more than one year (including TBG mall locations in 2019) that were open on a specific day of the week during the current period and the corresponding prior period. TBG salons were not a franchise locations in 2018 or 2020 so they are by definition excluded from same-store sales in 2018 and 2020. Year-to-date system-wide same-store sales are the sum of the system-wide same-store sales computed on a daily basis. Franchise salons that do not report daily sales are excluded from same-store sales. Locations relocated within a one-mile radius are included in same-store sales as they are considered to have been open in the prior period. System-wide same-store sales are calculated in local currencies to remove foreign currency fluctuations from the calculation.
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Consolidated Results of Operations
The following table sets forth, for the periods indicated, certain information derived from our Consolidated Statement of Operations. The percentages are computed as a percent of total revenues, except as otherwise indicated.
Fiscal Years
(Dollars in millions) % of Total Revenues (1) Basis Point (Decrease) Increase
Franchise rental income 127.2 — — 19.0 — — N/A N/A
Franchise rent expense 127.2 — — 19.0 — — N/A N/A
Long-lived asset impairment 22.6 — — 3.4 — — N/A N/A
Goodwill impairment 40.2 — — 6.0 — — N/A N/A
____________________________________________________________________________
(1)Cost of service is computed as a percent of service revenues. Cost of product is computed as a percent of product revenues.
(2)Excludes depreciation and amortization expense.
(3)Computed as a percent of loss from continuing operations before income taxes. The income taxes basis point change is noted as not applicable (N/A) as the discussion below is related to the effective income tax rate.
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Fluctuations in major revenue categories, operating expenses and other income and expense were as follows:
Consolidated Revenues
Consolidated revenues primarily include revenues of company-owned salons, product and equipment sales to franchisees franchise royalties and fees and franchise rental income. The following tables summarize revenues and same-store sales by concept, as well as the reasons for the percentage change:
Fiscal Years
(Dollars in thousands)
Franchise salons:
Franchise rental income 127,203 — —
Franchise same-store sales (decrease) increase (1) (4.4) % 0.3 % 2.1 %
Company-owned salons:
Percent change from prior year (37.4) % (13.5) % (4.4) %
_______________________________________________________________________________
(1)Franchise same-store sales are calculated as the total change in sales for salons that have been a franchise location for more than one year that were open on a specific day of the week during the current period and the corresponding prior period. Fiscal year franchise same-store sales are the sum of the franchise same-store sales computed on a daily basis. Franchise salons that do not report daily sales are excluded from same-store sales. Locations relocated within a one-mile radius are included in same-store sales as they are considered to have been open in the prior period. Franchise same-store sales are calculated in local currencies to remove foreign currency fluctuations from the calculation. TBG salons were not a franchise location in fiscal years 2018 or 2020 so by definition they are not included in franchise same-store sales in 2018 or 2020. TBG same-store sales are excluded from fiscal year 2019 same-store sales to be comparative to fiscal years 2018 and 2020.
(2)Company-owned same-store sales are calculated as the total change in sales for company-owned locations that were open on a specific day of the week during the current period and the corresponding prior period. Fiscal year company-owned same-store sales are the sum of company-owned same-store sales computed on a daily basis. Locations relocated within a one-mile radius are included in same-store sales as they are considered to have been open in the prior period. Company-owned same-store sales are calculated in local currencies to remove foreign currency fluctuations from the calculation.
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Fiscal Year Ended June 30, 2020 Compared with Fiscal Year Ended June 30, 2019
Consolidated Revenues
Consolidated revenues are primarily comprised of service and product revenues, as well as franchise royalties and fees, advertising fees and rental income.
Consolidated revenue decreased $399.3 million, or 37.4%. Service revenue and product revenue decreased $418.1 million and $88.0 million, respectively. The decline in service and product revenue is primarily the result of the Company's sale of salons to franchisees and the government-mandated salon closures in the fourth quarter. During fiscal year 2020, 1,448 salons were sold to franchisees, net of buy backs and 487 and 62 system-wide salons were closed and constructed, respectively (2020 Net Salon Count Changes). The impact to consolidated revenue due to the sale of salons to franchisees and closure of salons was $412.4 million. Additionally, the decline in revenue was a result of the temporary closure of all franchise and company-owned salons in the fourth quarter due to the COVID-19 pandemic. Royalties and fees decreased $20.4 million due to the refunding of $14.9 million of previously collected contributions to the cooperative advertising funds. Additionally, as a result of the Company's adoption of Topic 842, the Company now records revenue related to franchise leases and this adoption resulted in $127.2 million increase in franchise rental income for the year.
Service Revenues
The decrease of $418.1 million, or 55.8%, in service revenues during fiscal year 2020 was primarily due to 2020 Net Salon Count Changes. The impact to service revenue due to the sale of salons to franchisees and closure of salons was $350.8 million. Additionally, the temporary closure of salons in the fourth quarter and company-owned same-store service sales decreases also contributed to the decrease in service revenue. The company-owned same-store service sales decrease of 3.3% during fiscal year 2020 was primarily due to a 7.4% decrease in same-store guest transactions, partially offset by an increase of 4.1% in average ticket price.
Product Revenues
The decrease of $88.0 million, or 39.0%, in product revenues during fiscal year 2020 was primarily due to 2020 Net Salon Count Changes. The impact to product revenue due to the sale of salons to franchisees and closure of salons was $61.6 million. Company-owned same-store product sales decrease of 8.7% and the temporary closure of salons in the fourth quarter also contributed to the decrease in product sales. For fiscal year 2020, the decrease in company-owned same-store product sales was the result of a decrease in company-owned same-store transactions of 12.8%, partially offset by an increase in average ticket price of 4.1%.
Royalties and Fees
The decrease of $20.4 million, or 21.7%, in royalties and fees for fiscal year 2020 was primarily due to the refunding of $14.9 million of previously collected contributions to the cooperative advertising funds to provide temporary relief to our franchisees and the decline in royalties in the fourth quarter is due to government-mandated salon closures. Total franchised locations open at June 30, 2020 were 5,209 as compared to 3,951 at June 30, 2019.
Franchise Rental Income
The increase of $127.2 million in franchise rental income is due to the adoption of Topic 842 in fiscal year 2020. Prior to the adoption, the Company recorded franchise rental income and expense on a net basis.
Cost of Service
The 670 basis point increase in cost of service as a percent of service revenues during fiscal year 2020 was due to higher minimum wage and commissions and inefficient stylist hours.
Cost of Product
The 450 basis point increase in cost of product as a percent of product revenue during fiscal year 2020 was primarily due to the shift into lower margin wholesale product sales. Margins on retail product sales were 47.6% and 50.8% for fiscal years 2020 and 2019, respectively. Margins on wholesale product sales were 23.6% and 21.2% for fiscal years 2020 and 2019, respectively. The increase in wholesale product margins in fiscal year 2020 were primarily driven by lower sales to TBG.
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Site Operating Expenses
The decrease of $69.5 million, or 49.3%, in site operating expenses during fiscal year 2020 was due to a net reduction in company-owned salon counts, a decrease in cooperative advertising expense and a decrease in marketing spend. Salons sold to franchisees and closed salons accounted for $37.8 million of the decline. The Company records advertising expense as the contributions are received as it has an obligation to spend the funds to support the brands. In fiscal year 2020, the Company refunded $14.9 million in advertising fees that were previously collected to provide temporary relief to our franchisees. Marketing expense declined as part of our strategic shift to a full-franchised business model.
General and Administrative
The decrease of $46.1 million, or 26.0%, in general and administrative during fiscal year 2020 was primarily due to lower administrative and field management salaries due in part to the Company's furlough program in response to the COVID-19 pandemic and reductions in headcount as we align our cost structure with our transition to an asset-light franchise model. Stock compensation benefits associated with a change in performance awards assumptions also contributed to the decrease year over year.
Rent
The decrease of $55.4 million, or 42.1%, in rent expense during fiscal year 2020 was primarily due to the net reduction in salon counts associated with the Company's franchise strategy. Additionally, two months of rent abatement from Walmart and a decline in percentage rent, both due to COVID-19 salon closures, also contributed to the decline, but were partially offset by rent inflation.
Franchise Rent Expense
The increase in franchise rent expense is due to the adoption of Topic 842 in fiscal year 2020. Prior to the adoption, the Company recorded franchise rental income and expense on a net basis.
Depreciation and Amortization
The decrease of $0.9 million, or 2.4%, in depreciation and amortization during fiscal year 2020 was primarily due to the net reduction in company-owned salon counts, partially offset by an intangible asset impairment of $2.5 million.
Long-Lived Asset Impairment
In fiscal year 2020, the Company recorded a long-lived asset impairment charge of $22.6 million which included a right of use asset impairment of $17.4 million. Prior to the Adoption of ASC 842 in fiscal year 2020, we did not record a right of use asset so there was no impairment consideration. Additionally, salon asset impairment increased in fiscal year 2020.
TBG Mall Restructuring
In fiscal year 2020, the Company incurred professional fees associated with acquiring salons from TBG. In fiscal year 2019, the Company recorded a reserve against a note receivable of $8.0 million and accounts receivables of $12.7 million due from TBG primarily for inventory shipments.
Goodwill Impairment
In fiscal year 2020, Company recorded $40.2 million of goodwill impairment related to the Company-owned reporting unit. The Company's forecasted cash flows for company-owned salons decreased significantly due to the impact of the COVID-19 pandemic. As a result, the carrying value of the Company-owned reporting unit exceeded its fair value resulting in a full impairment of goodwill.
Interest Expense
The increase of $2.7 million in interest expense for fiscal year 2020 was primarily due to interest charges associated with the Company's long-term financing liabilities and the interest associated with the additional borrowing in fiscal year 2020.
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(Loss)/Gain from sale of salon assets to franchisees, net
In fiscal year 2020, the loss from sale of salon assets to franchisees was $27.3 million, including non-cash goodwill derecognition of $77.0 million. In fiscal year 2019, the gain from sale of salon assets to franchisees was $2.9 million, including non-cash goodwill derecognition of $67.1 million. The decrease year over year is due to lower proceeds per salon sold in fiscal year 2020 compared to fiscal year 2019 as the Company sold more Supercuts salons in fiscal year 2019, which typically vendition for greater proceeds than other concepts. In fiscal year 2020, average proceeds per salon were $62.1 thousand compared to $123.6 thousand in fiscal year 2019.
Interest Income and Other, net
The increase of $1.6 million, or 93.9%, in interest income and other, net during fiscal year 2020 was primarily due to the gain on the sale of the Company's headquarters of $2.5 million, partially offset by a decline in interest income.
Income Taxes
During fiscal year 2020, the Company recognized a tax benefit of $4.6 million, with a corresponding effective tax rate of 2.6% as compared to recognizing tax benefit of $2.1 million, with a corresponding effective tax rates of 9.6% during fiscal year 2019.
See Note 10 to the Consolidated Financial Statements in Part II, Item 8, of this Form 10-K.
Income from Discontinued Operations
Income from discontinued operations decreased $5.1 million, or 85.9%, during fiscal year 2020, due to the lapping of income tax benefits associated with the wind-down and transfer of legal entities related to discontinued operations recognized in the second quarter of fiscal year 2019, partially offset by beneficial actuarial adjustments recognized in the current year.
Fiscal Year Ended June 30, 2019 Compared with Fiscal Year Ended June 30, 2018
Consolidated Revenues
Consolidated revenues are primarily comprised of service and product revenues, as well as franchise royalties and fees. Service revenue decreased $149.7 million, or 16.6%, primarily due to the sale of salons to franchisees and a decline in company-owned same-store service sales of 0.3%. The Company closed 133 company-owned salons, constructed (net of relocations) 10 company-owned salons and sold (net of buybacks) 735 company-owned salons during fiscal year 2019 (2019 Net Salon Count Changes). Product revenue decreased $33.1 million or 12.8% due to lower sales to TBG and a system-wide decline of retail sales of 2.4% excluding TBG. Partially offsetting these decreases was an increase in royalty and fee revenue of $16.4 million, or 21.1%, due to the net addition of 644 non-TBG franchisees during the year.
Service Revenues
The $149.7 million decrease in service revenues during fiscal year 2019 was primarily due to the 2019 Net Salon Count Changes and a decrease in company-owned same-store service sales of 0.3%, which was primarily a result of a 4.7% decrease in same-store guest visits, partially offset by a 4.4% increase in average ticket price. Service revenues were also unfavorably impacted by a cumulative adjustment in the prior year related to discontinuing a piloted loyalty program that occurred in the prior year.
Product Revenues
The $33.1 million decrease in product revenues during fiscal year 2019 was primarily due to 2019 Net Salon Count Changes, a decline in product sold to TBG, the lapping of a one-time benefit related to discounted close-out product sales as part of the SmartStyle operational restructuring in the prior year and a decline in system-wide same-store product sales excluding TBG of 2.4%. The decrease in system-wide same-store product sales excluding TBG was primarily a result of a 6.0% decrease in transactions, partially offset by an increase in average ticket price of 3.6%.
Royalties and Fees
The increase of $16.4 million in royalties and fees during fiscal year 2019 was primarily due to higher royalties and advertising fund revenue due to an increase of 644 non-TBG franchisees in fiscal year 2019 and an increase of 0.3% in same-store sales at franchised locations excluding TBG.
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Cost of Service
The 140 basis point increase in cost of service as a percent of service revenues during fiscal year 2019 was primarily due to state minimum wage increases, a favorable shrink adjustment in the prior year and a one-time benefit from a settlement in fiscal year 2018.
Cost of Product
The 280 basis point increase in cost of product as a percent of product revenues during fiscal year 2019 was primarily due to higher discounting, the shift to lower margin wholesale product sales, favorable shrink adjustment in the prior year and a one-time benefit from a settlement in the prior year, partially offset by inventory reserves in the prior year related to the January 2018 SmartStyle portfolio restructure and lower franchise product sold to TBG. Margins on retail product sales were 50.8% and 52.0% in fiscal years 2019 and 2018, respectively. Margins on wholesale product sales were 21.2% and 21.6% in fiscal years 2019 and 2018, respectively.
Site Operating Expenses
Site operating expenses decreased $13.0 million during fiscal year 2019 due primarily to the 2019 Net Salon Count Changes, partially offset by higher advertising fund expense due to the increase in franchise salon counts, higher employment litigation reserves and higher contract maintenance, repairs and services costs related to open salons.
General and Administrative
General and administrative expense increased by $3.0 million during fiscal year 2019 primarily due to an $8.0 million gain in the prior year associated with life insurance proceeds, increased stock compensation and professional fees, partially offset by lower administrative, corporate and field salaries and bonuses.
Rent
Rent expense decreased by $51.3 million during fiscal year 2019 primarily due to lease termination fees and other related closure costs associated with the January 2018 SmartStyle portfolio restructure and the 2019 Net Salon Count Changes, partially offset by rent inflation.
Depreciation and Amortization
Depreciation and amortization expense decreased $20.4 million during fiscal year 2019, primarily due to costs in the prior year associated with returning certain SmartStyle locations to their pre-occupancy condition in connection with the January 2018 SmartStyle restructuring and lower depreciation due to a reduced salon base and lower salon asset impairments.
TBG Mall Restructuring
In fiscal year 2019, the Company recorded a reserve against a note receivable of $8.0 million and accounts receivables of $12.7 million due from TBG based on TBG’s inability to meet the requirements of the promissory notes, including non-payment of amounts due to the Company. The $8.0 million note relates to prior year inventory shipments and the $12.7 million of receivables primarily relates to current year inventory shipments. The remaining charge relates to reserves in connection with the settlement agreement with TBG in June 2019. There were no related TBG mall restructuring charges in fiscal year 2018.
Interest Expense
Interest expense decreased by $5.7 million during fiscal year 2019 primarily due to a lower outstanding principal and lower interest rates associated with the revolving credit facility compared to the retired senior term note and the lapping of the premium and unamortized debt discount expense associated with retirement of the senior term note in March 2018.
Gain from sale of salon assets to franchisees, net
In fiscal year 2019, the gain from sale of salon assets to franchisees was $2.9 million, including non-cash goodwill derecognition of 67.1 million. In fiscal year 2018, the gain from the sale of salons assets to franchisees was $0.2 million, including $3.9 million of non-cash goodwill derecognition.
Interest Income and Other, net
The $3.5 million decrease in interest income and other, net during fiscal year 2019 was primarily due to prior year income from transition services related to TBG and the lapping of interest income associated with life insurance contracts settled in June 2018.
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Income Taxes
During fiscal year 2019, the Company recognized an income tax benefit of $2.1 million on $22.3 million of loss from continuing operations before income taxes as compared to recognizing income tax benefit of $69.8 million on $10.2 million of loss from continuing operations before income taxes during fiscal year 2018. The recorded tax provision and effective tax rate for the twelve months ended June 30, 2019 were different than what would normally be expected primarily due to the deferred tax valuation allowance.
Additionally, the Company is currently paying taxes in Canada and certain states in which it has profitable entities.
See Note 10 to the Consolidated Financial Statements in Part II, Item 8, of this Form 10-K.
Income (Loss) from Discontinued Operations
Income from TBG discontinued operations was $5.9 million during fiscal year 2019 primarily due to tax benefits associated with the wind-down and transfer of legal entities. During fiscal year 2018, the Company recognized $53.2 million of loss, net of taxes from TBG discontinued operations, primarily due to asset impairment charges based on the sale prices and the carrying values of the mall-based salon business and the International segment, the recognition of net loss of amounts previously classified within accumulated other comprehensive income, professional fees associated with the transactions and losses from operations. See Note 3 to the Consolidated Financial Statements in Part II, Item 8, of this Form 10-K.
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Results of Operations by Segment
Based on our internal management structure, we report two segments: Franchise salons and Company-owned salons. See Note 15 to the Consolidated Financial Statements in in Part II, Item 8, of this Form 10-K. Significant results of operations are discussed below with respect to each of these segments.
Franchise Salons
Fiscal Years
(Dollars in millions) Increase (Decrease)
Revenue
Franchise rental income 127.2 — — 127.2 —
Franchise same-store sales (3) (4.4) % 0.3 % 2.1 %
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(1)Includes $1.6 million and $1.2 million of royalties related to TBG during the fiscal years 2019 and 2018, respectively.
(2)Total is a recalculation; line items calculated individually may not sum to total due to rounding.
(3)Franchise same-store sales are calculated as the total change in sales for salons that have been a franchise location for more than one year that were open on a specific day of the week during the current period and the corresponding prior period. Quarterly and year-to-date franchise same-store sales are the sum of the franchise same-store sales computed on a daily basis. Franchise salons that do not report daily sales are excluded from same-store sales. Locations relocated within a one-mile radius are included in same-store sales as they are considered to have been open in the prior period. Franchise same-store sales are calculated in local currencies to remove foreign currency fluctuations from the calculation. TBG salons were not a franchise location in fiscal years 2018 or 2020 so by definition they are not included in franchise same-store sales in 2018 or 2020. TBG same-store sales are excluded from fiscal year 2019 same-store sales to be comparative to fiscal years 2018 and 2020.
Franchise same-store sales by concept are detailed in the table below:
Fiscal Years
SmartStyle (9.7) % (5.6) % (3.0) %
Signature Style (3.5) % 0.1 % 2.1 %
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Fiscal Year Ended June 30, 2020 Compared with Fiscal Year Ended June 30, 2019
Franchise Salon Revenues
Franchise salon revenues increased $99.4 million during fiscal year 2020, excluding franchise rental income recorded as a result of the adoption of Topic 842, franchise salon revenues decreased $27.8 million compared to the prior comparable period. The decrease was due to the refund of previously collected contributions to the cooperative advertising funds, a waiver of fourth quarter advertising fees, as well as franchise product sales to TBG. Royalties were flat year over year despite the increase in franchise salon count, due to the fourth quarter government-mandated salon closures. Franchisees purchased (net of Company buybacks) 1,448 salons from the Company and constructed (net of relocations) and closed 47 and 237 franchise-owned salons, respectively.
Franchise Salon Operating Income
During fiscal year 2020, Franchise salon operations generated operating income of $32.9 million, an increase of $16.7 million compared to the prior comparable period. The increase was primarily due to the decrease in TBG mall restructuring costs.
Cash Generated from Salons Sold to Franchisees
During fiscal years 2020 and 2019, the Company generated $91.6 million and $94.8 million of cash respectively, from the sale of company-owned salons to franchisees. The decrease is due to lower proceeds per salon sold partially offset by an increase in the number of salons sold.
Fiscal Year Ended June 30, 2019 Compared with Fiscal Year Ended June 30, 2018
Franchise Salon Revenues
Franchise salon revenues increased $22.6 million during fiscal year 2019 due to a $8.3 million increase in franchise product sales and a $16.4 million increase in royalties and fees as a result of higher franchise salons counts, partially offset by lower product sales to TBG. Our franchisees constructed (net of relocations) 65 salons, purchased (net of Company buybacks) 735 salons from the Company and closed 156 salons (excluding TBG mall locations).
Franchise Salon Operating Income
Franchise salon operating income excluding TBG increased $2.4 million due to higher product and royalty revenue as a result of the increase in franchise salon count. Franchise salon operating income including TBG, decreased $19.5 million during fiscal year 2019 due to the TBG restructuring charge of $21.8 million related primarily to notes and accounts receivable reserves.
Cash Generated from Salons Sold to Franchisees
During fiscal years 2019 and 2018, the Company generated $94.8 million and $11.6 million of cash respectively, from the sale of company-owned salons to franchisees.
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Company-owned Salons
Fiscal Years
(Dollars in millions) Increase (Decrease)
Company-owned same-store sales (4.4) % (0.4) % 0.4 % (400 bps) (80 bps)
Fiscal Years
Supercuts (5.3) % (2.3) % 1.7 %
Signature Style (4.0) % (1.3) % (0.2) %
Fiscal Year Ended June 30, 2020 Compared with Fiscal Year Ended June 30, 2019
Company-owned Salon Revenues
Company-owned salon revenues decreased $498.7 million in fiscal year 2020, primarily due to the closure of a net 250 salons and the sale of 1,448 company-owned salons (net of buybacks) to franchisees during the year and the government-mandated temporary closure of our salons in third and fourth quarters due to the COVID-19 pandemic. The decreases were also due to company-owned same-store sale decrease of 4.4%. The company-owned same-store sales decrease was due to a decrease of 7.7% in same-store guest transactions, which were negatively impacted by the COVID-19 pandemic. This decrease was partially offset by an increase of 3.3% in average ticket prices.
Company-owned Salon Operating (Loss) Income
During fiscal year 2020, the company-owned salon operations incurred an operating loss of $96.1 million, compared to operating income of $58.3 million in the prior comparable period. The decrease was primarily due to the $71.9 million reduction in operating income due to the reduction in company-owned salons, the recording of a $40.2 million goodwill impairment charge due to the economic disruption of COVID-19, the closure of company-owned salons due to the COVID-19 pandemic, same-store sales decline and the right of use asset impairment. These declines were partially offset by an overall decline in general and administrative expense and marketing spend.
Fiscal Year Ended June 30, 2019 Compared with Fiscal Year Ended June 30, 2018
Company-owned Salons Revenues
Company-owned salon revenues decreased $189.0 million in fiscal year 2019, primarily due to the 2019 Net Salon Count Changes and same-store sales decrease of 0.4%. The same-store sales decrease was due to a 4.7% decrease in same-store guest visits, partially offset by a 4.3% increase in average ticket price.
Company-owned Salon Operating Income
Company-owned salon operating income increased $7.8 million during fiscal year 2019, primarily due to the January 2018 SmartStyle portfolio restructure consisting of lease termination and other related closure costs and costs associated with returning the salons to pre-occupancy condition, and field general and administrative savings primarily due to lower headcount. These increases were partially offset by the 2019 Net Salon Count Changes, state minimum wage increases, rent inflation and marketing investments.
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Corporate
Fiscal Year Ended June 30, 2020 Compared with Fiscal Year Ended June 30, 2019
Corporate Operating Loss (1)
Corporate operating loss of $82.1 million decreased $14.5 million during fiscal year 2020, primarily driven by lower general and administrative salaries and stock compensation benefits associated with a change in performance awards assumptions during the year, partially offset by the prior year's franchise convention cost, which was recorded as Corporate expenses in fiscal year 2020 compared to Franchise expense in fiscal year 2019.
Fiscal Year Ended June 30, 2019 Compared with Fiscal Year Ended June 30, 2018
Corporate Operating Loss (1)
Corporate operating loss of $96.6 million increased $5.3 million during fiscal year 2019 primarily driven by a prior year gain of $8.0 million associated with life insurance proceeds, partially offset by savings realized from Company initiatives, including lowering headcount and lower incentive compensation.
_______________________________________________________________________________
(1) The Corporate operating loss consists primarily of unallocated general and administrative expenses, including expenses associated with salon support, depreciation and amortization related to our corporate headquarters and unallocated insurance, benefit and compensation programs, including stock-based compensation.
Recent Accounting Pronouncements
Recent accounting pronouncements are discussed in Note 1 to the Consolidated Financial Statements in Part II, Item 8, of this Form 10-K.
LIQUIDITY AND CAPITAL RESOURCES
Sources of Liquidity
Funds generated by operating activities, available cash and cash equivalents, proceeds from sale of salons sold to franchisees, and our borrowing agreements are our most significant sources of liquidity.
As of June 30, 2020, cash and cash equivalents were $113.7 million, with $110.9, $2.6 and $0.2 million within the United States, Canada and Europe, respectively.
The Company has a credit agreement which provides for a $295.0 million five-year unsecured revolving credit facility that expires in March 2023, of which $96.5 million was available as of June 30, 2020. See additional discussion under Financing Arrangements and Note 8 to the Consolidated Financial Statements in Part II, Item 8, of this Form 10-K.
Uses of Cash
The Company closely manages its liquidity and capital resources. The Company's liquidity requirements depend on key variables, including the performance of the business, the level of investment needed to support its business strategies, capital expenditures, credit facilities and borrowing arrangements and working capital management. Capital expenditures are a component of the Company's cash flow and capital management strategy, which can be adjusted in response to economic and other changes to the Company's business environment. The Company has a disciplined approach to capital allocation, which focuses on investing in key priorities to support the Company's response to the COVID-19 pandemic, as well as its multi-year strategic plan as discussed within Part I, Item 1.
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Cash Flows
Cash Flows (Used In) Provided by Operating Activities
During fiscal year 2020, cash used in operating activities was $86.4 million. Cash from operations declined due to lower revenues and margins and the refunding of the cooperative advertising funds to Franchisees as a direct result of the COVID-19 pandemic, as well as lower same-store sales, partially offset by the elimination of certain general and administrative costs.
During fiscal year 2019, cash used in operating activities was $17.5 million, primarily as a result of a decline in Company-owned operating margin, strategic investment in new retail product lines and planned strategic G&A investments to enhance the Company's franchisor capabilities and support the increase in volume and cadence of transactions and conversions into the Franchise portfolio, partially offset by the elimination of certain general and administrative costs.
During fiscal year 2018, cash provided by operating activities was $2.6 million, primarily due to operating margin, partially offset by the payment of lease termination and other related closure costs associated with the Company's January 2018 SmartStyle portfolio restructures.
Cash Flows from Investing Activities
During fiscal year 2020, cash provided by investing activities of $61.0 million was primarily from cash proceeds from sale of salon assets of $91.6 million and the sale of the Company's headquarters of $9.0 million, partially offset by capital expenditures of $37.5 million.
During fiscal year 2019, cash provided by investing activities of $87.8 million was primarily from cash proceeds from sale of salon assets of $94.8 million and proceeds from company-owned life insurance policies of $24.6 million, partially offset by capital expenditures of $31.6 million.
During fiscal year 2018, cash used in investing activities of $1.1 million was primarily from capital expenditures of $30.7 million, partially offset by cash proceeds from company-owned life insurance policies of $18.1 million and cash proceeds from sale of salon assets of $11.6 million.
Cash Flows from Financing Activities
During fiscal year 2020, cash provided by financing activities of $56.2 million was primarily due to the net $87.5 million draw on the Company's line of credit and the repurchase of common stock of $28.2 million.
During fiscal year 2019, cash used in financing activities of $126.7 million was primarily for repurchase of common stock of $152.7 million and employee taxes paid for shares withheld of $2.5 million, partially offset by proceeds from the sale and leaseback of the Company's distribution centers of $28.8 million.
During fiscal year 2018, cash used in financing activities of $62.2 million was primarily for repayments of long-term debt relating to the 5.5% senior term notes of $124.2 million, repurchase of common stock of $24.8 million, employee taxes paid for shares withheld of $2.4 million and settlement of equity awards of $0.8 million, partially offset by borrowings on the revolving credit facility of $90.0 million.
Financing Arrangements
Financing activities are discussed in Note 8 to the Consolidated Financial Statements in Part II, Item 8, of this Form 10-K. Derivative activities are discussed in Part II, Item 7A, "Quantitative and Qualitative Disclosures about Market Risk."
The Company's financing arrangements consists of the following:
(Fiscal year) (Interest rate %) (Dollars in thousands)
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As of June 30, 2020 and 2019, the Company had $177.5 and $90 million, respectively, of outstanding borrowings under a $295.0 million revolving credit facility. The five-year revolving credit facility expires in March 2023 and includes a minimum liquidity covenant of not less than $75.0 million, provides the Company's lenders security in substantially all of the Company's assets, adds additional guarantors and grants a first priority lien and security interest to the lenders in substantially all of the Company’s and the guarantors’ existing and future property. The revolving credit facility includes a $30.0 million sub-facility for the issuance of letters of credit and a $30.0 million sublimit for swingline loans. The Company may request an increase in revolving credit commitments under the facility of up to $115.0 million under certain circumstances. The applicable margin for loans bearing interest at LIBOR ranges from 3.75%-4.25%, the applicable margin for loans bearing interest at the base rate ranges from 2.75%-3.25% and the facility fee ranges from 0.5%-0.75%, each depending on average utilization of the revolving line of credit.
In fiscal year 2019, the Company sold its Salt Lake City and Chattanooga Distribution Centers to an unrelated party. The Company is leasing the properties back for 15 years with the option to renew. As the Company plans to lease the property for more than 75% of its economic life, the sales proceeds received from the buyer-lessor are recognized as a financial liability. This financial liability is reduced based on the rental payments made under the lease that are allocated between principal and interest.
Our debt to capitalization ratio, calculated as the principal amount of debt as a percentage of the principal amount of debt and shareholders' equity at fiscal year-end, was as follows:
As of June 30, Debt toCapitalization Basis PointIncrease (Decrease)(1)
_______________________________________________________________________________
(1)Represents the basis point change in debt to capitalization as compared to prior fiscal year-end.
The basis point increase in the debt to capitalization ratio as of June 30, 2020 compared to June 30, 2019 was primarily due to the increase in the Company's borrowings.
The basis point increase in the debt to capitalization ratio as of June 30, 2019 compared to June 30, 2018 was primarily due to the repurchase of $8.6 million shares of common stock for $152.7 million.
Contractual Obligations and Commercial Commitments
The following table reflects a summary of obligations and commitments outstanding by payment date as of June 30, 2020:
Payments due by period
(Dollars in thousands)
On-balance sheet:
_______________________________________________________________________________
(1)The total lease liability does not include interest. Payments due by period are the payments due per the lease agreement and include embedded interest. Therefore, the total payments do not equal the liability.
(2)Upon adoption of ASC 842 in fiscal year 2020, the operating leases were recorded on the balance sheet so there are no off-balance sheet liabilities.
On-Balance Sheet Obligations
Our debt obligations are primarily composed of our revolving credit facility at June 30, 2020.
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Finance lease liabilities are related to sale and leaseback transactions for two distribution centers at June 30, 2020.
Other long-term liabilities of $7.0 million include $4.4 million related to a Non-qualified Deferred Salary Plan and a salary deferral program of $2.6 million related to established contractual payment obligations under retirement and severance agreements for a small number of employees.
Operating leases primarily represent long-term obligations for the rental of salons, including leases for company-owned locations, as well as salon franchisee lease obligations, which are reimbursed to the Company by franchisees. Regarding franchisee subleases, we generally retain the right to the related salon assets, net of any outstanding obligations, in the event of a default by a franchise owner. The Company has not experienced any material losses as a result from these arrangements; however, the COVID-19 pandemic may result in an increase in defaults which may be material.
This table excludes short-term liabilities disclosed on our balance sheet as the amounts recorded for these items will be paid in the next year. We have no unconditional purchase obligations. Also excluded from the contractual obligations table are payment estimates associated with employee health and workers' compensation claims for which we are self-insured. The majority of our recorded liability for self-insured employee health and workers' compensation losses represents estimated reserves for incurred claims that have yet to be filed or settled.
The Company has unfunded deferred compensation contracts covering certain management and executive personnel. Because we cannot predict the timing or amount of future payments related to these contracts, such amounts were not included in the table above. See Note 11 to the Consolidated Financial Statements in Part II, Item 8, of this Form 10-K.
As of June 30, 2020, we have liabilities for uncertain tax positions. We are not able to reasonably estimate the amount by which the liabilities will increase or decrease over time; however, at this time, we do not expect a significant payment related to these obligations within the next fiscal year. See Note 10 to the Consolidated Financial Statements in Part II, Item 8, of this Form 10-K.
Off-Balance Sheet Arrangements
Interest payments on long-term debt are calculated based on the revolving credit facility's rates. The applicable margin for loans bearing interest at LIBOR ranges from 3.75%-4.25%, the applicable margin for loans bearing interest at the base rate ranges from 2.75%-3.25% and the facility fee ranges from 0.5%-0.75%, each depending on average utilization of the revolving line of credit.
We are a party to a variety of contractual agreements under which we may be obligated to indemnify the other party for certain matters, which indemnities may be secured by operation of law or otherwise, in the ordinary course of business. These contracts primarily relate to our commercial contracts, operating leases and other real estate contracts, financial agreements, agreements to provide services and agreements to indemnify officers, directors and employees in the performance of their work. While our aggregate indemnification obligation could result in a material liability, we are not aware of any current matter that we expect will result in a material liability.
We do not have other unconditional purchase obligations or significant other commercial commitments such as standby repurchase obligations or other commercial commitments.
We do not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet financial arrangements or other contractually narrow or limited purposes at June 30, 2020. As such, we are not materially exposed to any financing, liquidity, market or credit risk that could arise if we had engaged in such relationships.
Dividends
In December 2013, the Board of Directors elected to discontinue declaring regular quarterly dividends.
Share Repurchase Program
In May 2000, the Company's Board of Directors (Board) approved a stock repurchase program with no stated expiration date. Since that time and through June 30, 2020 , the Board has authorized $650.0 million to be expended for the repurchase of the Company's stock under this program. All repurchased shares become authorized but unissued shares of the Company. The timing and amounts of any repurchases depends on many factors, including the market price of the common stock and overall market conditions. During fiscal year 2020, the Company repurchased 1.5 million shares for $26.4 million. As of June 30, 2020, 30.0 million shares have been cumulatively repurchased for $595.4 million, and $54.6 million remained outstanding under the approved stock repurchase program.
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CRITICAL ACCOUNTING POLICIES
The Consolidated Financial Statements are prepared in conformity with accounting principles generally accepted in the United States of America. In preparing the 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 Consolidated Financial Statements. We base these estimates on historical experience and other assumptions believed to be reasonable under the circumstances. Estimates are considered to be critical if they meet both of the following criteria: (1) the estimate requires assumptions about material matters that are uncertain at the time the accounting estimates are made, and (2) other materially different estimates could have been reasonably made or material changes in the estimates are reasonably likely to occur from period to period. Changes in these estimates could have a material effect on our Consolidated Financial Statements.
Our significant accounting policies can be found in Note 1 to the Consolidated Financial Statements in Part II, Item 8, of this Form 10-K. We believe the following accounting policies are most critical to aid in fully understanding and evaluating our reported financial condition and results of operations.
Goodwill
As of June 30, 2020 and 2019, the Company-owned reporting unit had $0.0 and $117.8 million of goodwill, respectively, and the Franchise reporting unit had $227.5 and $227.9 million of goodwill, respectively. See Note 5 to the Consolidated Financial Statements. The Company assesses goodwill impairment on an annual basis, during the Company’s fourth fiscal quarter, and between annual assessments if an event occurs, or circumstances change, that would more likely than not reduce the fair value of a reporting unit below its carrying amount.
Goodwill impairment assessments are performed at the reporting unit level, which is the same as the Company’s operating segments. The goodwill assessment involves a one-step comparison of the reporting unit’s fair value to its carrying value, including goodwill (Step 1). If the reporting unit’s fair value exceeds its carrying value, no further procedures are required. However, if the reporting unit’s fair value is less than the carrying value, an impairment charge is recorded for the difference between the fair value and carrying value of the reporting unit.
In applying the goodwill impairment assessment, the Company may assess qualitative factors to determine whether it is more likely than not that the fair value of the reporting units is less than its carrying value (Step 0). Qualitative factors may include, but are not limited to, economic, market and industry conditions, cost factors, and overall financial performance of the reporting unit. If after assessing these qualitative factors, the Company determines it is “more-likely-than-not” that the carrying value is less than the fair value, then performing Step 1 of the goodwill impairment assessment is unnecessary.
The carrying value of each reporting unit is based on the assets and liabilities associated with the operations of the reporting unit, including allocation of shared or corporate balances among reporting units. Allocations are generally based on the number of salons in each reporting unit as a percent of total company-owned salons or expenses of the reporting unit as a percentage of total company expenses.
The Company calculates estimated fair values of the reporting units based on discounted cash flows utilizing estimates in annual revenue, service and product margins, fixed expense rates, allocated corporate overhead, corporate-owned and franchise salon counts, proceeds from the sale of company-owned salons to franchisees and long-term growth rates for determining terminal value. Where available and as appropriate, comparative market multiples are used in conjunction with the results of the discounted cash flows. The Company engages third-party valuation consultants to assist in evaluating the Company's estimated fair value calculations. See Note 1 to the Consolidated Financial Statements in Part II, Item 8, of this Form 10-K
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Long-Lived Assets, Excluding Goodwill
The Company assesses impairment of long-lived salon and right of use assets at the individual salon level, as this is the lowest level for which identifiable cash flows are largely independent of other groups of assets and liabilities, when events or changes in circumstances indicate the carrying value of the assets or the asset grouping may not be recoverable. Factors considered in deciding when to perform an impairment review include significant under-performance of an individual salon in relation to expectations, significant economic or geographic trends, and significant changes or planned changes in our use of the assets. The first step is to assess recoverability and in doing that the undiscounted cash flows are compared to the carrying value. If the undiscounted estimated cash flows are less than the carrying value of the assets, the Company calculates an impairment charge based on the difference between the carrying value of the asset group and its fair value. The fair value of the salon long-lived asset group are estimated using a market participant model based on the best information available, including salon level revenues and expenses. The fair value of the right of use asset is estimated by determining what a market participant would pay over the life of the primary asset in the group, discounted back to June 30, 2020. The impairment is allocated to long-lived assets based on relative carrying value, but not impaired below fair value. Long-lived property and equipment asset impairment charges related to continuing operations of $3.9, $4.6 and $11.1 million were recorded during fiscal years 2020, 2019 and 2018, respectively in Depreciation and Amortization in the Consolidated Statement of Operations. A long-lived asset, including right of use and salon property and equipment, impairment charge of $22.6 million was recorded during fiscal year 2020 and is separately stated on Consolidated Statement of Operations. Of the total $22.6 million long-lived asset impairment charge, $17.4 million was allocated to the right of use asset and $5.2 million was allocated to salon property and equipment.
Judgments made by management related to the expected useful lives of salon long-lived assets and the ability to realize undiscounted cash flows in excess of the carrying amounts of such assets are affected by factors, such as the ongoing maintenance and improvement of the assets, changes in economic conditions and changes in operating performance. Right of use asset values are impacted by market rent rates. As the ongoing expected cash flows and carrying amounts of long-lived assets are assessed, these factors could cause the Company to realize material impairment charges.
Income Taxes
Deferred income tax assets and liabilities are recognized for the expected future tax consequences of events that have been included in the Consolidated Financial Statements or income tax returns. Deferred income tax assets and liabilities are determined based on the differences between the financial statement and tax basis of assets and liabilities using currently enacted tax rates in effect for the years in which the differences are expected to reverse.
We recognize deferred tax assets to the extent that we believe these assets are more likely than not to be realized. The Company evaluates all evidence, including recent financial performance, the existence of cumulative year losses and our forecast of future taxable income, to assess the need for a valuation allowance against our deferred tax assets. While the determination of whether or not to record a valuation allowance is not fully governed by a specific objective test, accounting guidance places significant weight on recent financial performance.
The Company has a valuation allowance on its deferred tax assets amounting to $122.4 and $70.7 million at June 30, 2020 and 2019, respectively. If we determine that we would be able to realize our deferred tax assets in the future in excess of their net recorded amount, we would make necessary adjustments to the deferred tax asset valuation, which would reduce the provision for income taxes.
Significant components of the valuation allowance which occurred during fiscal year 2020 are as follows:
•In connection with the Coronavirus Aid, Relief and Economic Security Act (CARES Act), Net Operating Losses (NOLs) resulting from accounting periods which straddled December 31, 2017 are now considered definite-lived NOLs. Therefore, the Company established a valuation allowance against the U.S. NOLs generated during its fiscal year 2018 and recorded a net tax expense of $14.7 million.
•The Company determined that it no longer had sufficient U.S. indefinite-lived taxable temporary differences to support realization of its U.S. indefinite-lived NOLs and its existing U.S. deferred tax assets that upon reversal are expected to generate indefinite-lived NOLs. As a result, the Company recorded an additional $17.0 million valuation allowance on its U.S. federal indefinite-lived deferred tax assets.
•The Company recognized a capital loss and established a corresponding valuation allowance of $14.9 million on investment outside basis previously impaired for financial accounting purposes.
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The Company reserves for unrecognized tax benefits, interest and penalties related to anticipated tax audit positions in the U.S. and other tax jurisdictions based on an estimate of whether additional taxes will be due. If payment of these amounts ultimately proves to be unnecessary, the reversal of these liabilities would result in tax benefits being recognized in the period in which it is determined that the liabilities are no longer necessary. If the estimate of unrecognized tax benefits, interest and penalties proves to be less than the ultimate assessment, additional expenses would result.
Inherent in the measurement of deferred balances are certain judgments and interpretations of tax laws and published guidance with respect to the Company's operations. Income tax expense is primarily the current tax payable for the period and the change during the period in certain deferred tax assets and liabilities.
See Note 10 to the Consolidated Financial Statements in Part II, Item 8, of this Form 10-K.
Item 7A. 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, specifically the revolving credit facility, which bears interest at variable rates based on LIBOR plus an applicable borrowing margin. Additionally, the Company is exposed to foreign currency translation risk related changes in the Canadian dollar and to a lesser extent the British pound. The Company has established policies and procedures that govern the management of these exposures through the use of derivative financial instrument contracts. 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 earnings implications associated with volatility in short-term interest rates. In the past, the Company has used 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. In addition, access to variable rate debt is available through the Company's revolving credit facility. The Company reviews its policy and interest rate risk management quarterly and adjusts in accordance with market conditions and the Company's short and long-term borrowing needs. As of June 30, 2020, the Company had outstanding variable rate debt of $177.5 million. As of June 30, 2020, the Company did not have any outstanding interest rate swaps.
Foreign Currency Exchange Risk:
Over 92% of the operations 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 and to a lesser extent the British pound. In preparing the 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 (AOCI). 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 June 30, 2020, the Company did not have any derivative instruments to manage its foreign currency risk.
During fiscal years 2020, 2019 and 2018, the foreign currency (loss) gain included in (loss) income from continuing operations was $(0.1), $0.1 and $(0.1) million, respectively. During fiscal year 2018, the Company recognized within discontinued operations a $6.2 million foreign currency translation loss in connection with the Company's liquidation of substantially all foreign entities with British pound denominated currencies.
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Item 8. Financial Statements and Supplementary Data
Index to Consolidated Financial Statements:
Report of Independent Registered Public Accounting Firm 51
Notes to Consolidated Financial Statements 60
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Report of Independent Registered Public Accounting Firm
To the Board of Directors and Shareholders of Regis Corporation
Opinions on the Financial Statements and Internal Control over Financial Reporting
We have audited the accompanying consolidated balance sheet of Regis Corporation and its subsidiaries (the “Company”) as of June 30, 2020 and 2019, and the related consolidated statements of operations, of comprehensive (loss) income, of shareholders' equity and of cash flows for each of the three years in the period ended June 30, 2020, including the related notes (collectively referred to as the “consolidated financial statements”). We also have audited the Company's internal control over financial reporting as of June 30, 2020, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of the Company as of June 30, 2020 and 2019, and the results of its operations and its cash flows for each of the three years in the period ended June 30, 2020 in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of June 30, 2020, based on criteria established in Internal Control - Integrated Framework (2013) issued by the COSO.
Change in Accounting Principle
As discussed in Note 1 to the consolidated financial statements, the Company changed the manner in which it accounts for leases as of July 1, 2019.
Basis for Opinions
The Company's management is responsible for these consolidated financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in Management’s Report on Internal Control over Financial Reporting appearing under Item 9A. Our responsibility is to express opinions on the Company’s consolidated financial statements and on the Company's internal control over financial reporting based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (PCAOB) and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.
We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement, whether due to error or fraud, and whether effective internal control over financial reporting was maintained in all material respects.
Our audits of the consolidated financial statements included performing procedures to assess the risks of material misstatement of the consolidated financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the consolidated financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.
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Definition and Limitations of Internal Control over Financial Reporting
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
Critical Audit Matters
The critical audit matters communicated beloware mattersarising from the current period audit of the consolidated financial statements that were communicated or required to be communicated to the audit committee and that (i) relate to accounts or disclosures that are material to theconsolidated financial statements and (ii) involved our especially challenging, subjective, or complex judgments. The communication of critical audit matters does not alter in any way our opinion on the consolidated financial statements, taken as a whole, and we are not, by communicating the critical audit matters below, providing separate opinions on the critical audit matters or on the accounts or disclosures to which they relate.
Goodwill Impairment Assessment as of March 31, 2020 – Franchise Reporting Unit
As described in Notes 1 and 5 to the consolidated financial statements, the Company’s consolidated goodwill balance was $227.5 million as of June 30, 2020, which is fully attributed to the Franchise reporting unit. Management assesses goodwill impairment on an annual basis as of April 30, 2020, and between annual assessments if an event occurs, or circumstances change, that would more likely than not reduce the fair value of a reporting unit below its carrying amount. During the third quarter of fiscal year 2020, the Company determined a triggering event occurred, resulting in quantitative impairment tests performed over the goodwill. This determination was made considering the reduced sales and profitability projections for the reporting unit, driven by the COVID-19 pandemic and related economic disruption. As a result of the triggering event impairment testing, the Franchise reporting unit was determined to have a fair value that exceeded carrying value by approximately 50 percent. The fair value of the Franchise reporting unit was determined based on a combination of a discounted cash flow model and a market model. The significant assumptions used in determining fair value for the March 31, 2020 assessment were the, number of salons to be sold to franchisees and the discount rate.Management subsequently updated the triggering event impairment assessment with its annual impairment test of the Franchise reporting unit as of April 30, 2020.
The principal considerations for our determination that performing procedures relating to the goodwill triggering event impairment assessment of the Franchise reporting unit is a critical audit matter are the significant judgment by management when determining the fair value measurement of the reporting unit, which in turn led to a high degree of auditor judgment, subjectivity, and effort in performing procedures and evaluating audit evidence related to (i) management’s discounted cash flow model (ii) significant assumptions related to the number of salons to be sold to franchisees and the discount rate. In addition, the audit effort involved the use of professionals with specialized skill and knowledge.
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Addressing the matter involved performing procedures and evaluating audit evidence in connection with forming our overall opinion on the consolidated financial statements. These procedures included testing the effectiveness of controls relating to management’s triggering event goodwill impairment assessment for the Franchise reporting unit, including controls over the valuation of the Franchise reporting unit. These procedures also included, among others,(i) testing management’s process for determining fair value of the reporting unit; (ii) evaluating the appropriateness of the discounted cash flow model; (iii) testing the completeness, accuracy, and relevance of underlying data used in the model; and (iv) evaluating the significant assumptions used by management relating to the number of salons to be sold to franchisees and the discount rate. Evaluating management’s assumption related to the number of existing franchised salons and the number of salons to be sold to franchisees involved evaluating whether the assumption used by management were reasonable considering current and past performance of the reporting unit and whether these assumptions were consistent with evidence obtained in other areas of the audit. Professionals with specialized skill and knowledge were used to assist in the evaluation of the Company’s discounted future cash flow model and the discount rate assumption.
Right of Use Asset Impairment Assessment for the Salon Asset Groups
As described in Notes 1 and 6 to the consolidated financial statements, the Company’s consolidated Right of Use Asset (ROUA) balance was $786.2 million as of June 30, 2020. As a result of COVID-19 and the related store closures that occurred during the fourth fiscal quarter of 2020, management determined that a triggering event had occurred and was required to perform a quantitative impairment assessment in the fourth fiscal quarter fiscal 2020. The Company first assessed all of its salon asset groups, which included the ROU assets, to determine if the carrying value was recoverable, which is determined by comparing the net carrying value of the salon asset group to the undiscounted net cash flows to be generated from the use and eventual disposition of that asset group. For the salon asset groups that failed the recoverability test, an impairment loss was measured as the amount by which the asset group exceeds its fair value. As described by management, the results of this assessment indicated that the estimated fair value of a portion of the Company’s salon asset groups did not exceed the carrying value and an impairment charge was recorded in the amount of $17.4 million to the ROUA balance. The fair value of the salon asset groups were determined from the perspective of a market participant considering various factors. The significant judgments and assumptions used in determining the fair value of the salon asset groups were the market rent of comparable properties based on recently negotiated leases as applicable, asset group’s projected sales for fiscal years 2021 through 2023 for properties with no recently negotiated leases, and a discount rate. The Company engaged a third-party valuation specialist to assist with significant inputs and assumptions utilized in the measurement of the impairment loss.
The principal considerations for our determination that performing procedures relating to the ROUA impairment assessment of the salon asset groups that failed the long-lived asset recoverability test is a critical audit matter are the significant judgement by management when developing the fair value measurement of the asset groups, which in turn led to a high degree of auditor judgment, subjectivity, and effort in performing procedures and evaluating audit evidence related to (i) management’s methods and calculations and, (ii) significant judgments and assumptions related to the market rent of comparable properties based on recently negotiated leases as applicable, asset group’s projected sales for fiscal years 2021 through 2023 for properties with no recently negotiated leases, and the discount rate. In addition, the audit effort involved the use of professionals with specialized skill and knowledge.