TLDR:

• Franchisor European Wax Center has been a strong growth story since its founding 18 years ago.

• But the company has benefited from a constructive external environment; that’s changing.

• At 19x EBITDA, the stock isn’t cheap even if targets are hit.

• A real path exists to a sub-$10 share price and 30%-plus downside. Investors willing to short should be looking closely at EWCZ.

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This is not a terribly easy market to find short opportunities. A violent sell-off — the S&P 500 is now down 25% year-to-date — has brought valuations in. After that decline, we’ve heard a number of intelligent investors argue there is real fundamental value in the market now. At least from a long-term perspective.

We’re not quite that bullish on valuations. But much of the froth that dominated 2020 and 2021 certainly has dissipated. And it’s obviously possible that we could be near a long-term bottom.

Meanwhile, there’s the risk of a “face-ripping” rally in the near term. On Thursday, the S&P rose 5% intraday. We talked last month about the difficulty in being short in this environment, and that argument still holds.

But even in that context, we see a strong case for shorting European Wax Center EWCZ 0.00 . We should have been earlier to this story admittedly: EWCZ is down 32% just since mid-August.

Even here, however, the stock looks overvalued. And that analysis is based on current results and guidance — which don’t appear to incorporate looming macroeconomic pressures. Add in a leveraged balance sheet, and a clear risk to next month’s earnings, and there’s a strong case for shorting EWCZ, even at the lows.

The Broad Case for European Wax Center

European Wax Center is the largest out-of-home waxing business in the country. The company was started in 2004 by two brothers in the back of their father’s Florida hair salon. At the end of the second quarter, EWC had nearly 900 locations, all but five of which are franchised.

As of March of last year, the company had six times as many locations as its next-largest competitor, and ten times the revenue. Following continued, aggressive expansion — EWC added 85 locations over the following five quarters, with a guided 43 to 45 more in the second half of this year — the gap has almost certainly expanded.

That scale should provide an enormous advantage. EWC works with beauty schools to attract waxing technicians in a tight labor market. It is the largest buyer of depilatory wax in the country, providing supply certainty and cost savings. And the company can market across locations, notably through its loyalty program and its Wax Pass, which provides discounts (such as Buy 9, Get 3 Free) for guests who pre-pay for services.

Results to this point suggest the strategy has worked quite well:

source: EWCZ S-1

Obviously, the coronavirus pandemic tanked 2020 results — all of the company's locations closed at one point — but business has bounced back. 2021 system-wide sales1 were up 16% from 2019; same-store sales rose 7% over the same period with lingering pandemic impacts and labor constraints in the key market of California. The midpoint of 2022 guidance assumes 10% comps and another 12%-plus increase in system-wide sales.

There’s little reason to believe inorganic growth has to end. EWC sees whitespace of more than 3,000 locations over time. It plans to increase store count 7% to 10% annually.

Of course, the franchise model makes that growth potentially highly profitable. In 2021, EWC generated 56% of revenue from product sales (wax and retail products sold to franchisees); 24% from royalties (6% of gross sales net of product sales); 14% from marketing fees (3% of gross sales net of product sales); and 6% from other sources (corporate revenue, technology fees, etc.). The company is guiding for Adjusted EBITDA margins of ~35% this year, and 25%-plus even adding back stock-based compensation. Capital expenditures are exceedingly low — $559,000 in 2021 — and earlier this year EWC leveraged up at a five-year fixed rate of just 5.5%.

Over time, new store count growth should both increase revenue and drive continued, if modest, expansion in EBITDA and free cash flow margins. Same-store sales should benefit from both market share gains and higher sales of products, including proprietary treatments for ingrown hairs and irritation. All told, there’s seemingly a path towards years of free cash flow growth ahead.

Managing Through The Macro

Obviously, any consumer services case at the moment faces the twin risks of inflation and, amid a quick succession of Federal Reserve interest rate hikes, recession. But EWC management would argue, and has argued, that their business is well-positioned to power through.

First, per the Q2 conference call, European Wax Center customers have attractive demographics. Average household income is over $100K, and higher for the most frequent customers. With an average ticket of $34, those customers presumably will cut spending elsewhere if they need to.

That’s particularly true because many customers don’t see out-of-home waxing as a discretionary purchase. Visiting a center is an easier, less messy, and usually less painful alternative to in-home alternatives. Indeed, as EWC notes in the S-1, in the years before the pandemic the OOH waxing market grew at an 8% CAGR against 3% for the market as a whole.

Inflation and/or recession could provide competitive benefits as well. EWC has estimated that the pandemic led to the closure of roughly 10% of independent salons. Lower demand and/or cost pressures could further reduce competition. The company’s scale may well prove a greater benefit in a more difficult environment.

It’s tempting perhaps to believe that waxing demand is going to drop precipitously in a more difficult environment. European Waxing Center management would disagree, as shown by both commentary and guidance for a double-digit increase in same-store sales and a 13% to 18% increase in Adjusted EBITDA, excluding the impact of public company costs.

Is Business Weakening?

But, already, some cracks are showing in that thesis.

Most notably, full-year guidance is not nearly as impressive as it sounds. Same-store sales rose 29% year-over-year in Q1, and 16% in the first half. The full-year outlook thus implies comps of 4%-plus in the second half (there should be a bit of overweighting toward the second half).

Even that 4% figure is coming in what is probably, on net, a beneficial environment. California alone was a ~460 basis point drag on consolidated comps in the second half of last year, per management commentary. But by Q1 2022, management was saying the market had “achieved its expected 2022 run rate faster than we had anticipated”, even if staffing in the state remains below pre-COVID levels.

EWC should also be benefiting from pricing. After an increase last year, the company put in another hike on body services in January. Retail products (~6% of revenue) went up in Q2. The company also ramped advertising in Q2 and Q3, and appears to have taken a more promotional cadence (including a Buy 3, Get 1 Wax Pass).

Finally, even in Q2 to Q4 there should be some kind of tailwind from the return to normalcy. Management said after Q3 2021 results that facial services demand was still impacted by mask mandates. There should be upside in that specific category in Q3 2022, as well as a more general comfort with non-essential services.

In the context of these multiple, material, tailwinds, 4-5% second-half comp growth, and maybe 6% in Q2-Q4 even accounting for some demand pulled into Q1, looks weak rather than strong.

Post-Q2 commentary strengthens the conclusion that the business here is nowhere close to recession-proof. On the call, EWC admitted that there had been some increased time between visits among customers — while also boasting that top-20% customers had increased their visitation and spending.

Net/net, that looks like a negative. The core customer — and the top quintile that drives ~half of revenue — is performing as might be expected given tailwinds from comps and a return to normalcy. It’s the less-frequent, less-committed customers that are already starting to react to changes in the external environment.

Of Course Macro Is A Problem

And those are precisely the customers EWC has to worry about. The attractiveness of the franchise model is that revenue drops to the bottom line at relatively high rates. But that’s obviously a double-edged sword.

When revenue stops growing, there’s very little a franchisor can do. There aren’t costs to take out. The issue is magnified for EWC, which levered up earlier this year to pay out a $3.30 per share special dividend.

Thanks to a $400 million bond issuance that funded part of that dividend, EWC’s net leverage ratio even at year-end, and even if guidance is hit, should clear 5x. Interest expense will total ~30% of 2022 Adjusted EBITDA.

EWC levered up to take advantage of the incremental margins inherent in the franchisor model. But margin expansion only arrives if revenue grows. Same-store sales performance in Q2, and guidance for the second half, both suggest a high risk that comp growth is starting to stall out. It’s the less committed customers that are needed to drive long-term growth, in terms of both present revenue and as a base of higher-usage guests going forward. If that cohort is cracking, overall comps likely do the same.

And that’s before any sign of slowing services spending in the U.S. In fact, “other services” outlays grew 9% year-over-year in Q2, according to Bureau of Economic Analysis figures.

Comp weakness ostensibly can be offset to some degree by new store count growth. But inflation and recession represent potential headwinds there as well. EWC itself notes in the 10-K (p. 13):

In particular, because nearly all of the development of additional centers is likely to be funded by franchisee investment, our growth strategy is dependent on our existing and prospective franchisees’ ability to access funds to finance such development. We do not generally provide our franchisees with direct financing…In addition, labor and material costs expended will vary by geographical location and are subject to general price increases.

Management has said that the near-term pipeline is largely backed by self-funding entities, including mid-market private equity funds and family offices. But it’s not clear whether even those investors might back away in a macro downturn. (Chief executive officer David Berg said on the Q2 call that those investors are “contractually committed” to developments, but the details of those contracts aren’t clear.) Franchisees will have to bear rising costs for both development and operations, and nearly all future development is targeting existing markets (EWC now operates in 45 states).

The idea that EWC is immune to a downturn seems overly optimistic, to put it mildly. Management has said that comps grew during the financial crisis, but that was a very different business: franchising only began in 2008.

Valuation And A Catalyst

A 42% year-to-date decline to some extent has priced in these pressures. But even with EWCZ closing Friday just above all-time lows, the stock hardly looks cheap.

Current enterprise value is $1.35 billion, or 19x the midpoint of this year’s Adjusted EBITDA guidance. Price to normalized free cash flow is probably in the 25x range, and above 30x accounting for stock-based compensation2.

Without a direct peer, or even an indirect peer, it’s difficult to necessarily put those multiples into context. Based on respective outlooks for 2022, EWCZ trades at roughly the same multiple as Planet Fitness PLNT 0.00. The two companies have a surprisingly similar growth profile this year, but Planet Fitness is the more proven and (potentially) more defensive name.

Exponential Fitness XPOF 0.00 might be a better peer, given its size, and it trades at about 15x this year's EBITDA guidance (with much stronger growth than EWC). Elsewhere in franchised services (a small peer set on the public markets), The Joint JYNT 0.00 is at a similar EV/EBITDA multiple, though with still-thin margins.

There’s a reasonable path here for multiples to compress to 15x EBITDA, which puts EWCZ below $10. And while that peer analysis is not particularly exhaustive, on an absolute basis it’s clear that EWCZ is pricing in consistent, material free cash flow growth going forward. It’s not at all clear that the company is going to be able to drive that growth.

There’s also a high valuation being placed on the whitespace opportunity. EWC’s franchise revenues are being valued at ~$1.5 million per location, even though development fees top out below $600,000 and per EWC itself locations hit ~$1 million in revenue at maturity (five years in).

Finally, there’s one more aspect to consider. EWC has essentially the same valuation at the moment as it did at its IPO price 14 months ago. The stock price has come down ~10%, but both share count and debt have increased. To be sure, EWCZ did rally sharply after going public (and closed up more than 20% on its first day of trading), but there’s an inherent attractiveness to shorting a cyclically-exposed business at the same valuation assigned in August 2021, even if that valuation came in an IPO.

Of course, this fundamental analysis assumes that EWC’s guidance for the year remains intact. In this environment, betting against any company’s outlook is intriguing given how much has changed just since the last update (in this case, on Aug. 4). That’s particularly true here given earnings due early next month, current investor sentiment, the signs of weakness seen in the Q2 report, and the leverage on the balance sheet.

Again, there are risks, and the leverage on the balance sheet can work against a short if broader sentiment improves or Q3 earnings surprise to the upside. But even at the lows, the rewards from a short seem to outweigh those risks.

As of this writing, Vince Martin has no positions in any securities mentioned. He may initiate a short position in EWCZ this week.

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