Showing a clear sensitivity to wages

Australian investors that were able to catch our recent national roadshow (video here) will know that we position Montaka’s long and short portfolios to take advantage of medium-term trends we are observing in the global economy.

We talked about a short position in Montaka’s portfolio called Regis Corporation (NYSE: RGS) – a network of around 9,000 budget hairdressing salons located across the US. Operating on razor thin profit margins already[1] and, with the largest component of its cost structure in employee-wages, Regis is negatively exposed to wage growth in the US.

And wages are growing. Indeed, they are accelerating, as illustrated below. It was for this reason that the Federal Reserve hiked interest rates in the US for the first time last December since 2006.

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Indeed, based on subsequent improvement in the US economy, Fed governors now largely believe that an additional 25 basis point hike in June may well be appropriate. The recent release of minutes from the Fed’s April meeting confirmed as much and sent market-implied probabilities of additional rate rises this year flying, as illustrated below.

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Back to Regis. Yesterday, the US Department of Labor updated its overtime regulations which will allow 4.2 million American salaried workers, for the first time, to become eligible for overtime rates of pay when they work more than 40 hours per week.

Something interesting then happened. Broker Piper Jaffray downgraded Regis on the basis that the new rules would wipe out substantially all of the company’s earnings at its current run rate. Regis then requested the New York Stock Exchange suspend trading in its stock pending an announcement. Regis said:

“In its report, Piper Jaffray significantly lowered its estimates by incorporating up to $81 million of incremental costs associated with the new U.S. Department of Labor overtime rules, issued yesterday. Regis Corporation has been following the status of these rule changes for the past several months and analyzing the potential impact of the new rules to the company’s profitability. The Company’s assessment suggests these new rules could increase our costs by up to $5 million per year, and is considering alternative mitigation strategies to reduce this increase. The large difference between Piper Jaffray’s report and the Company’s estimates is due to the fact that our salon managers and a large portion of our district leaders are already treated as hourly employees. Piper Jaffray’s estimates assumed these employees were salaried employees.”

While Piper Jaffray likely overestimated the impact of this particular rule (and subsequently upgraded the stock), the big takeaway for investors is the sensitivity of Regis’ earnings to wage cost pressures. To the extent wage growth continues to accelerate – as the Fed is seeking to ensure – this will be highly detrimental to the profitability of Regis going forward.

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Montaka is short the shares of Regis.

[1] Earnings before interest, tax & depreciation were just 4.6% of revenue over the last twelve months.

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Andrew Macken is a Portfolio Manager with Montgomery Global Investment Management. To learn more about Montaka, please call +612 7202 0100.

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