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Beating the Street: Mr. Lynch Got a Haircut

A prospectus for a new haircutting chain, Supercuts (formerly CUTS, now RGS), arrived on Peter Lynch's desk in late 1991. As one who always likes to do field research, Lynch promptly headed off to a Boston location and got himself a haircut. His family, friends and colleagues all panned the "shorn" look and recommended he not go there again.

Despite the loss of his sideburns, he told us in chapter ten of his 1993 book "Beating the Street" that this would be one of those relatively rare cases in which he wouldn't like the product but could still love the company.


From a financial perspective, there was much to like about Supercuts. It had gone public in October 1991 at $11 per share with more than 650 franchise shops already in place. The hair care industry at that time generated between $15 and $40 billion per year and was dominated by mom-and-pop barbershops. As Lynch pointed out, hair grows half an inch a month on some 250 million heads (at that time), and someone needed to cut it.

He compared the company to Service Corporation International (NYSE:SCI), which had successfully rolled up independently-owned funeral homes. "People were dying at a regular rate, somebody was going to have to bury them, and the industry was made up of hundreds of inefficient small operators whose children wanted to go to law school."

Because Supercuts was a franchise operation, franchisees were paying for the company's expansion, an attractive proposition if a shop was able to make the 50% pretax return promised in the prospectus. Supercuts, the franchisor, received 5% of the gross revenues and 4% of hair products sold in the shops. Administrative costs were low, with the biggest item being the cost of hiring a trainer at $40,000 per year for every 10 shops. At the same time, each set of 10 new shops would add revenue of $300,000 per year.

The emphasis within the shops was on quickly performing standard haircuts, and each stylist was forecast to bring in $30 per hour while keeping costs low. "Other than the rent for the retail space, the biggest ongoing expenditures in a hair salon are for scissors and combs."

Lynch being Lynch, he also had this droll observation:


"There's always something new to learn on these forays--did you know that haircutters have to be licensed? I didn't, but they do, and that's more than you can say for fund managers. There are no requirements for managing billions of dollars, but before somebody can trim your sideburns, he or she has to pass some sort of a test. Given the record of the average fund manager over the last decade, maybe it should be the other way around."



In a phone call with a Supercuts executive, Lynch learned that turnover of stylists had been low thanks to regular refresher courses, medical benefits and good tips. On the financial side, the company representative advised that the company was generating $5.4 million per year in free cash flow, which would apply to its debt and pay off all debt by 1993, just two years in the future. Erasing that debt would free up $2.1 million a year.

The competition was manageable, with Mastercuts, Fantastic Sam's and unisex shops in J.C. Penney (NYSE:JCP) as competing chains. Mastercuts put its shops in malls, where the rents were higher and the clientele mostly female. Fantastic Sam's had twice the number of franchise shops, but its revenues per shop were about half those of Supercuts. J.C. Penney shops appeared only in J.C. Penney stores.

In addition, Supercuts was the only one that opened Sundays and evenings, and the company had a national advertising campaign that would distinguish it from its competitors.

At chapter's end, Lynch summarized, "This was a 20% grower at the initial stages of its takeoff, selling for 16 times earnings at the time I recommended it.... In the end, the excellent numbers won out over the lost sideburns".

Conclusion

Once again, Lynch has given us an entertaining story to illustrate his approaches to investing. In chapter ten, he described how he got to know Supercuts.

He used a chance encounter with its prospectus (of which he received thousands a month), a visit to a company shop, a phone call to a company executive and fundamental analysis to identify a stock that had the potential to grow 20% per year.

He also reminded us that sideburns grow back at the rate of half an inch per month.

Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.

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This article first appeared on GuruFocus.