European Wax Center (NASDAQ:EWCZ) offers franchising opportunities in the waxing space. The company franchises one of the largest networks of waxing centers across the US with more than 970 centers with close to $1 billion of system-wide sales. But despite their strong success in both growth and profitability, the stock has been underperforming. We believe this is the market reaction to the growing competitive threat presented by laser hair removal competitors, and its impact is still unclear. Overall, we would like to keep EWCZ on close watch but we do not feel confident at the current valuation level yet.
Franchise business model: fast-growing at record margins
The business model is very simple: provide a standardized and unique platform to offer the same service, at similar prices, in the whole country. Out-of-home waxing services have been consistently growing in popularity, with around 46% of women using waxing as the preferred hair removal method, and the industry is expected to grow at more than 9% annually through 2028.
Overall, EWCZ has been successful in capturing these trends, and its financial results reflected this.
Both center count and system-wide sales have been growing consistently. Revenues of the company are then collected as a royalty of total sales per center, which stands at 6% right now. Also, they have been able to capture significant market share, as they are 6x times larger than their largest competitor. Additionally, the existing market appears deeply fragmented, allowing for greater expansion potential.
The majority of wax service providers are indeed currently mom-and-pop stores and not large chains like EWCZ. This means that the marketing spending ROI is far greater and much more impactful. And what about margins and profitability? Well, since this is a franchise business, the margins are superior to the ones of the waxing centers.
The company has 30% EBITDA margins and has been improving them consistently over the years. As the fixed cost base remained constant while topline figures grew, the overall profitability improved. We think this is a reasonable run-rate EBITDA margin, but wouldn’t be surprised if there is further improvement from here.
Laser competition: what this could mean for EWCZ in the long run
So far the story seems great. Fast-growing, highly profitable, fragmented market. Every piece is here as the foundation for a great increasing stock price story, which however does not materialize. In fact, the stock has been underperforming for the past year, with no sign of a reversal soon.
This is despite a strong guidance of around $80 million of adjusted EBITDA by the end of 2024, which would imply an EV/EBITDA of around 11x. Definitely a conservative figure for a fast-growing and highly profitable franchise business. We believe that the main reason behind this is the competitive threat posed by laser hair loss removal. While also offering other product lines, EWCZ vast majority of system-wide sales are derived from their waxing services (as one may anticipate). This means that a competitive service that is (1) cheaper, and (2) long-lasting, is a significant issue for the business.
A quick analysis provides a clearer picture of why this competition exists. Time savings and cost savings can compound very quickly and in a reasonable period of 20 years, laser is the undisputable winner. But so far this competition has been limited by one main factor: short-term expenses related to the laser are significantly higher than waxing, making it harder to access for low-income customers. However, we think this is rapidly coming to an end, and laser could soon be competing at a price range very close to waxing, making the competition much stronger (and dangerous). A NYC-based laser provider called “Infinity Laser Spa” is currently offering “One year of Laser Hair Removal for $99”. When compared with $40-70 of waxing offered by EWCZ it is clear that they are now in the same league.
We believe the company somewhat confirmed these concerns by launching a laser program in the NYC area. From the latest earnings call:
As we've discussed over the last two quarters, we believe that offering additional hair removal modalities could be an effective method of attracting new guests to the brand, increasing share of wallet from existing wax guests and enhancing already robust four wall economics over time. We launched our pilot laser test in six New York area centers in Q4 and have been pleased with the results seen thus far. We were able to generate strong sales from both new and existing guests while minimalizing cannibalization of existing core waxing services.
While cannibalization may be limited, the main issue with laser is its non-recurring nature. While waxing has a relatively short duration of weeks or months at best, the effects of laser can easily last for 5-6 years, or even after. This means that there will likely be a demand crunch once 30-40% of the customer population uses the service.
Last but not least, we think the program is also much more expensive than expected. From the call:
Second, this range includes approximately $4 million of operating expenses, which are foundational and mostly onetime in nature to support our expanded laser hair removal pilot
Management disclosed around $4 million of one-time expenses related to the launch of the program in just 6 centers. This translates into around $650k per center. This is an astronomical figure compared to the average investment of around $400k per center for the existing franchises.
Valuation: assessing risks and opportunities
All in all, EWCZ has a great business model that is currently set on a healthy growth path in a highly fragmented market. The franchise nature of their business model makes it highly profitable, with superior margins and cash generation. However, the laser competition poses a significant risk in the medium and long run, and we feel this needs to be embedded in the valuation. In order to properly evaluate this business we will use a scenario-based DCF model with two scenarios:
Bear case: laser will be widely implemented and would be competing at similar price ranges across the entire country. This would translate into depressed and negative topline growth rates after 2028, and declining margins as a result of increased marketing spending. Under this scenario, we assume a 5% growth rate and 30% EBITDA margins up to 2028, -3% growth rate afterward at 25% EBITDA margins.
Bull case: laser will not be able to compete at similar price points other than in a few key metropolitan areas. This could easily be the case if rural non-urban areas are slow to adopt new, expensive technology and will leave a gap for EWCZ to benefit from. Under this scenario, the company is expected to grow at 12% up to 2028 and 8% afterward, at an average EBITDA margin of 32%.
In both cases, the discount rate applied is derived from the WACC, which stands at around 9%. The terminal growth rate is 2% in both scenarios, as the company is expected to grow reasonably along with the entire economy.
The first scenario yields a fair price per share of $3.5, corresponding to a total EV of $518 which, after subtracting $300 million in net debt, translates into a $218 million equity value. We feel comfortable assigning a probability of 40% to this scenario.
The bull case, on the other hand, reveals the upside potential of the business itself. This means a fair price per share of around $14. This scenario has an implied 60% probability. This is a snapshot of our forecast of FCF over the years for the bull case:
We believe a slightly depressed cash generation will affect the 2024-2028 period as the company continues to invest in growth through higher marketing spending (i.e. lower EBITDA margin). However, later on this will benefit in terms of margin expansion and higher cash generation (see 2029 jump).
All in all, the probability-weighted fair price stands at $9.8, with a downside potential of around 15% from the current price. Our conclusion is to remain on the sidelines and look for the following: (1) continued growth and little risk posed by the laser competitors, and/or (2) a drop in the share price below our target, which could create an entry opportunity.
Conclusion
European Wax Center has all the right cards to play in the top league of franchise companies. However, a significant risk to the business model is currently posed by laser competitors, which could translate into a more difficult growth path going forward. We believe the current price is still too generous to justify an entry point, but we will be looking again if it falls below our target of $9.8.
Hydra Research
We focus on special situations and deep value plays. We are open to L/S positioning that allows us to capture inefficiencies both on the upside and downside. For the long positioning, we like to spot asymmetric opportunities where the downside is relatively limited and the upside is not understood by the market - like restructurings, spin-offs, takeover targets, etc. We are a research group and from time to time we also take positions in the stocks we discuss publicly here on Seeking Alpha.
Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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