Regis Corp (RGS) 2005 Q2 法說會逐字稿

Good morning. My name is Carol and I will be your conference facilitator today. At this time I would like to welcome everyone to the Regis Corporation's second quarter 2005 earnings conference call. (OPERATOR INSTRUCTIONS). If anyone has not received a copy of this morning's press release please call Regis Corporation at 952-947-7798, and a copy will be faxed to you immediately. If you wish to access the replay for this call you may do so by dialing 888-203-1112. Use access code 8983384.

I would like to remind you that to the extent the Company's statements or comments this morning represent forward-looking statements, I refer you to the risk factors and other cautionary factors in today's news release, as well as the Company's SEC filings. Reconciliation to non-GAAP financial measures mentioned in the following presentation can be found on their Website at www.regiscorp.com.

With us this morning are Paul Finkelstein, Chairman and Chief Executive Officer, and Randy Pearce, Chief Financial Officer and Executive Vice President. After management has completed its review of the quarter, we will open the call for questions. (OPERATOR INSTRUCTIONS). I would now like to turn the call over to Paul Finkelstein for his comments.

Good morning everyone and thank you for joining us. As you know from our January 4th press release, we are disappointed with our second quarter performance. Second quarter revenues did increase 14 percent to $537 million, including 8.4 million of Hair Club revenues. Second quarter same-store sales came in below plan, increasing .4 of 1 percent. Service comps increased .7 of 1 percent, and retail comps decreased .2 of 1 percent.

SmartStyle, Trade Secret and International positively comped despite difficult year-over-year comparisons. December same-store sales decreased .6 of 1 percent. Second quarter net income decreased 3 percent to $26.8 million, or 58 cents a share. Several items negatively impacted our second quarter net income, a $1.5 million book to physical inventory charge, increased marketing expenses, reduced service margins, and most importantly, lower-than-expected comps in December.

Despite the reduction in second quarter net income, EBITDA increased 1 percent to $67 million. We ended the quarter with 10,518 units, including 10,412 salons, 91 hair restoration centers, and 15 beauty schools. We had 743 more locations as of December 31, compared to our unit count on December 31, 2003.

We increased our unit count by 256 during the quarter. During the quarter we completed 16 transactions, acquiring 91 hair restoration centers and 69 salons, including 9 franchise buybacks, and 4 beauty schools. Organically we built 124 corporate salons and closed or relocated 54 others.

Total debt at the end of the quarter was $520 million. And our debt-to-cap ratio was 40.3 percent. Debt-to-EBITDA ratio was 2.0.

Let's talk about the highlights for the quarter. Obviously the number 1 event was the acquisition of Hair Club for Men and Women. The hair loss industry is highly profitable. Hair Club is by far and away the leading industry provider of hair loss solutions, with an estimated 4 to 5 percent of the $4.3 billion domestic market. The industry is comprised of approximately 4,000 locations domestically, and is highly fragmented. As a result, we believe there's a huge opportunity to consolidate the industry through the acquisition of Ma's and Pa's and Hair Club franchisees.

In addition to a highly profitable business model driven largely by high margin recurring service fees, we were attracted to Hair Club for several reasons. Hair Club is run by an exceptional group of individuals. The existing management team has increased the EBITDA margin at Hair Club from 11 percent to the mid-20 percent range in the last 2 years. Hair Club is the only provider of all 3 hair restoration solutions, hair systems, hair transplants and hair therapy. We believe this provides Hair Club an advantage over their competition in this highly fragmented industry.

We feel that Hair Club has significant growth opportunities. Hair transplants have only recently been introduced. Only a handful of centers perform transplants. Many more existing centers will soon add this profitable service. Also, women now comprise 45 percent of new customers contrasted to 3 percent of new customers just 3 years ago. We are excited about these incremental growth opportunities.

In addition to acquisitions, our plan for Hair Club growth includes the construction of a modest number of new locations in untapped markets domestically and internationally. It is interesting to note that the real estate criteria are very different for Hair Club. In an effort to provide confidentiality for their customers, hair restoration centers operate primarily in professional or medical office buildings.

Finally, with over 155 million transactions in our salons each year we estimate that 3 million Regis customers have hair loss issues. Thus we have a unique opportunity to implement cross marketing initiatives, and to drive many of our existing salon customers to Hair Club to address their hair loss issues. This could prove to be a cost-effective method of adding new customers.

Every 1,000 new Hair Club system customers translates into at least an incremental penny per share. So even if we're modestly successful in converting our salon customers to Hair Club, we are quite optimistic that we will be able to drive incremental earnings through cross marketing efforts.

During the second quarter, in addition to the Hair Club acquisition, we acquired 69 salons and 4 schools. Acquisition activity will be extremely robust this year, however, this activity will be more back end loaded this fiscal year, which will help next year's earnings growth.

On January 24 we issued a press release describing our acquisition activity. The numbers are enormous. And through the third quarter we anticipate buying 400 Company-owned salons and at least 13 beauty schools. And that number is quite conservative.

We also have made a substantial minority investment in a Dallas, Texas-based company called Cool Cuts 4 Kids, which focuses on the children's business. Cool Cuts presently has 59 units. And we hope that when we exercise our purchase option in 3 to 4 years, it will have several hundred children salons in the fold. It is interesting to note that children's visitation patterns are not really related to fashion. They are even more predictable than adult visitation patterns.

Thus acquisition activity this year will be record-breaking in terms of dollars spent. And we will be spending almost $500 million buying and building locations. This bodes extremely well for 2006 and beyond.

I do want to address the issue of long hair. L'Oreal recently released survey information on the European market, which is identical to the U.S. market, confirming the fact that salon visitation patterns were reduced by 2.8 percent from 2001 to 2003. We believe this trend continues to impact our business and is largely due to the long hair phenomenon. We have experienced this type of fashion trend before, and we know that it definitely cycles. Comps will eventually return to historical levels, resulting in additional EPS increases.

Let me try to simplify our current strategy and challenges. First, accelerate our acquisitions and new store builds, because comps will be lackluster for quite awhile due to long hair. Second, maintain our margins. Price cutting is not an appropriate strategy. Third, and most importantly, be patient and focus on the morale of our fantastic field supervisor and management, our Company's most valuable asset. In these times they need our support more than ever.

We're certainly not satisfied with our revised extremely modest projected fiscal 2005 EPS growth, but we have been through this before. Fiscal 2001 was a flat year. We are however very bullish about 2006 and beyond. We now have 3 platforms for men's growth, our traditional salon business, the beauty school business, and hair restoration. We continue to forecast double-digit top and bottom line growth over any 5 or 10 year period of time.

Randy Pearce will now continue with our presentation.

Good morning everyone. Before I get started with the usual detailed review of our operating results, I would just like to address a couple of items with you. First of all, as Paul mentioned, we're certainly disappointed today to report quarterly results below our long-term growth expectations.

While revenues increased nearly 14 percent during the quarter, our net income fell 3 percent to $26.8 million, or 58 cents per share. Although the 58 cents meets the midpoint of our revised earnings guidance, these results fell about 8 cents short of the midpoint of our initial earnings guidance for the quarter. I thought I would take a moment right up front to try to reconcile this 8 cent shortfall by identifying and quantifying 4 major items contributing to the miss. I will get into more detail in a few moments when I review the various revenue and expense line items on the P&L, so for now I will be brief.

We estimate that about 3 cents of the miss was related to comps coming in below plan during the quarter. We have said in the past that on an annual basis for every 1 percent increase or decrease in comps, that equates to 10 to 12 cents per share of earnings on an annual basis. So once again, about 3 cents of the quarterly miss related to comps coming in below plan.

On top of this we incurred an additional 2 cents per share of expense associated with higher salon payroll costs, which have now been corrected. Another 2 cents per share related to higher supply and retail product costs, largely in our United Kingdom salon operations. And lastly, our advertising expenditures came in about a penny per share higher this quarter than we had anticipated. Again, these are the major factors, none of which are systemic.

The second item I wanted to address with you deals with the format of our P&L. I'm sure as by now you have noticed that in today's press release we have condensed and simplified the format of our consolidated income statement. This was done as a result of our recent forays into the beauty school and hair restoration businesses. As you are aware, our acquisitions of beauty schools caused us to add a few new line items to the face of our P&L. And now with the recent addition of Hair Club, we were faced with the prospect of adding several more line items. We felt that our income statement was becoming increasingly difficult to read and to comprehend, so as a result we made a decision to streamline our P&L in order to make our operating results more transparent and easier to grasp.

However, for those of you interested in more detail, we're also providing a supplemental consolidating P&L that provides additional information on our salon, our hair restoration and our beauty school businesses. This will help you assess the operating performance of each of these businesses. And again that supplemental consolidating P&L is attached to today's press release.

For those of you that model our financials, we have also provided some historical quarterly income statements in this new format going back to fiscal 2003. You can find this information in the Investor Information section of our corporate website at www.regiscorp.com.

All of my comments this morning regarding our second quarter performance will follow the new format of our consolidated income statement. Please remember that even with the recent additions of the beauty school and Hair Club businesses, our traditional salon operations will still generate well over 90 percent of our consolidated revenues and profits. As a result, I generally do not plan to ever reference the more detailed supplemental P&L, whether now or in the future, unless there is some significant fluctuation that is worth calling attention to. So let me jump in now and I'll give you a bit more detail behind our second quarter results starting first with a discussion of our revenues.

Our second quarter consolidated revenue increased 14 percent to a record $537 million. As you know, our long-term growth expectations include both organic as well as acquisition growth, with each representing roughly half of our total revenue growth. This quarter our organic growth, which included a same-store sales increase of 40 basis points. Our organic growth represented 46 percent of our total revenue growth, while acquisitions made within the previous 12 months represented the remaining 54 percent.

Obviously, these percentages will vary on a quarter by quarter basis due to the timing of new store openings and acquisitions. However, over a longer period of time the mixture of organic and acquisition growth should be very consistent with our long-term expectations. You'll find a table in our press release today that breaks out our second quarter revenues for each of our concepts.

Let's now talk about our service sales line item on the P&L. In addition to the service revenue generated within our beauty salons, this line item now includes tuition and service revenue from our beauty schools, as well as service revenue from Hair Club for Men and Women. Service sales in the second quarter of our current fiscal year increased 16.5 percent to $357 million.

The next revenue item on the P&L, which is product sales, includes revenue from the sale of retail product in our beauty salons, revenue associated with the product we sell to our salon franchisees, as well as retail product sales made by Hair Club and our beauty schools.

Total retail product sales, which have a higher gross margin rate than service sales, grew 8.7 percent in the second quarter of fiscal 2005 to $160 million. In addition, our retail product sales mix for the quarter was 29.8 percent of consolidated revenue, which was slightly lower than the product mix of 31.2 percent we reported in the same quarter last year when we enjoyed an 8.4 percent increase in retail product comps.

The next revenue line item is royalty and fees, which grew 8.5 percent in the second quarter to $20 million. The growth in franchise royalty and fees is primarily related to our European franchise business, as well as our recent acquisition of Hair Club for Men and Women, which includes 49 franchise centers.

Our franchise business remains healthy as evidenced by the 77 new franchise salons we built during the quarter. We believe that our franchisees should build about 300 new salons during the entire fiscal year. Please keep in mind, however, that the overall net number of franchise units will generally not change much due to our franchise buyback activity.

As we reported in our press release on January 7, consolidated same-store sales for the quarter increased 40 basis points which was below the lower end of our second quarter forecasted range of 1 to 2 percent.

While we have modestly had positive same-store -- I'm sorry -- modestly positive service comps for 4 quarters in a row, including the growth of 70 basis points in our December quarter, our service business continues to be impacted by the longer hair fashion trend, as well as the economy. Long-term, we anticipate that our service same-store sales should return to the range of 2 to 4 percent.

Our retail product comps declined 20 basis points in the second quarter, but again we were up against a very strong increase of 8.4 percent in the second quarter last year. We continue to anticipate modest growth in retail product comps in the near-term as we anniversary some difficult comparisons in the coming months ahead. Long-term however, we forecast retail product comps to be in the 2 to 4 percent range.

Before I get into a discussion of the various expense line items on the P&L, I want to once again mention that beginning with today's press release we have made some modifications to the format of our consolidated P&L in order to simplify it. This was once again done as a result of our recent entries into the beauty schools and Hair Club businesses, and the anticipated future growth of the segments. The format change we made to the P&L resulted in some slight reclassifications of certain revenue and expense items. I will start by talking first about our second quarter gross margins.

Our second quarter overall combined gross margin rate came in below plan at 44.3 percent of total service and product sales, which was 100 basis points lower than the comparable period last year. As I will discuss in a moment, the decline in our combined gross margin rate was impacted both by service as well as product.

First we will talk about service margins. Our second quarter service margin rate came in at exactly 43 percent, which was 110 basis points lower than the rate we reported in the second quarter a year ago. This was primarily due to 2 factors. The first was due to higher than expected salon payroll costs, which we have now corrected in January. The second factor was due to increased salon supply costs in our United Kingdom business, as evidenced by our book to physical inventory adjustment. We are aggressively tackling this problem and are committed to fix it in the near-term. Looking ahead, we expect our service margin rate to be stronger for the remainder of fiscal 2005, in the upper 43 percent range.

I will now discuss our retail product margins. During the second quarter our retail product margins came in below plan at 47.3 percent, which was 50 basis points lower than the same period a year ago. This decline was primarily related to an increase in product cost, once again as evidenced by our $1.5 million overall book to physical inventory adjustment. The vast majority of this adjustment related to our United Kingdom operations where we buy product directly from distributors rather than directly from vendors.

We are aggressively taking the appropriate action to enhance our systems and our controls in the United Kingdom in order to reduce the likelihood that this type of an adjustment will reoccur. Longer-term we hope to have enough critical mass in Europe to perhaps support an inventory distribution center much like the 2 that we own and operate here in United States. Product margins for all of fiscal 2005 are expected to be in the mid 47 percent range of product revenue.

Next, let me now address of new line item on the P&L called site operating expenses. This expense category includes direct costs incurred by our salons, by our beauty schools, and by our hair restoration centers. Such expenses include items such as advertising, insurance, utilities, and janitorial costs. Again these are direct costs incurred. We make no cost allocations to this expense category.

Site operating expenses came in at 8.3 percent of second quarter consolidated sales, identical to the second quarter rate last year. In terms of the 8.3 percent rate the negative leverage that we experienced from reduced comps was offset primarily by the addition of the Hair Club business, which has lower site operating expenses than our salon business. Looking ahead to the balance of our current 2005 fiscal year we expect that site operating expense category should continue to be in the low 8 percent range of consolidated sales.

I will now address our general and administrative costs, which we used to call corporate and franchise support costs. All of the expenses within the G&A category relate to costs associated with our field supervision, our salon training and promotions, our distribution centers, and our corporate offices which now include support offices for our beauty schools and our Hair Club businesses.

This expense category for the second quarter of fiscal 2005 came in at 11.9 percent of consolidated sales, a 40 basis point increase compared to the same quarter last year. This quarter over quarter increase in rate was primarily due to 2 factors. The first relates to the addition of the Hair Club business, which had slightly higher G&A costs due to the marketing intensive nature of that business. The second factor that contributed to the rate increase was a lower-level of same-store sales growth in the quarter. We do expect the full 2005 fiscal year rate to be in the mid 11 percent range of consolidated revenue.

I will now discuss rent. Our consolidated rent expense in the second quarter came in at 13.9 percent of consolidated revenue, which was 20 basis points higher than last year, primarily due to reduced level of overall same-store sales growth between the 2 periods. We expect our rent expense rate for all of fiscal 2005 to be approximately 14 percent of consolidated revenue.

I will now switch to depreciation and amortization expense. In the past we reported 2 depreciation and amortization expense line items. One was for our salons and the other for our corporate offices and our distribution centers. In an effort to simplify our income statement we have now combined these two line items into one. During the second quarter this D&A -- second quarter this year, our D&A was 3.9 percent of consolidated revenue, which was comparable to the 4 percent rate we reported in the same period a year ago. Looking ahead to the balance of our current fiscal year, we expect that our D&A rate should increase slightly due to the amortization of various intangible assets we acquired in recent Hair Club transaction. For the full fiscal year we expect that our D&A rate should approximate 4 percent of consolidated revenue.

Our second-quarter operating income was just over $45 million, or 8.4 percent of consolidated sales. That was a reduction of $2 million, or 160 basis points, from the same period a year ago. As we discussed, most of the decline was gross margin related. Despite a challenging quarter, we believe that our overall operating income rate for all of fiscal 2005 should come in just under 9 percent.

Let me now drop down to interest expense, which came in at $5.5 million for the quarter, or 1 percent of consolidated sales. That $5.5 million was up slightly from the $4.3 million of interest expense we reported in our preceding first quarter. The increase in interest expense was related primarily to our acquisition activity during the second quarter that included the $210 million purchase of Hair Club for Men and Women. Taking into account the Hair Club acquisition, our total debt at the end of December came in at $520 million, which was up $219 million more than the $301 million of debt we had at the fiscal year end at June 30. Our debt to capitalization ratio, however, continues to remain solidly investment grade standing at 40.3 percent at the end of December.

We continue to feel that our internal cash flow and our available debt capacity should be sufficient to cover our expansion costs, as well as our scheduled debt retirements and our dividend payments. During all of fiscal 2005 we expect to spend 90 to $100 million of our cash flow to acquire salons, and an additional $60 million or so to acquire beauty schools. We also plan to spend 100 to $115 million for capital expenditures, including the construction of 550 to 600 new corporate salons. Based on these budget assumptions, as well as our recent Hair Club acquisition, we are now expecting that our debt levels at the end of our current 2005 fiscal year should approximate $610 million, and our debt to capitalization ratio should end the year in the low 40 percent range.

Just a few more items. Our consolidated effective income tax rate came in at 34.1 percent in the second quarter, which was very close to the rate we had expected. This rate represents a reduction of 240 basis points over the same period a year ago due to the Company's continued growth in lower tax rate jurisdictions outside the United States, as well as recent tax legislative initiators that we previously discussed with you. At this point in time we continue to expect that our income tax rate for the next 2 quarters and for all of fiscal 2005 should approximate 35 percent.

In total, our second quarter net income declined by $898,000 to $26.8 million, or 58 cents per diluted share, compared to 60 cents per share that we reported in the second quarter last year.

Consistent with our revised outlook that we communicated on January 4, we continue to project consolidated revenue for the full fiscal year to be approximately $2.2 billion, with same-store sales increasing about 1 percent. Diluted earnings per share are expected to be in the range of $2.35 to $2.47 cents per share, an increase of 3 to 8 percent over the previous fiscal year. Once again for a detailed summary of our guidance, please visit our corporate website.

Lastly, let me now provide you just a few pieces of information regarding our salon counts. At the end of the second quarter, the end of December, we had a total of 10,518 corporate and franchise locations. In today's press release you'll find a table that breaks out our unit count for each of our concepts.

So that said. Paul and I would now like to answer any questions you have. So, Carol, if you could step in and provide instructions, we would appreciate that.

(OPERATOR INSTRUCTIONS). Mark Chekanow with Sidoti.

Could you talk -- I guess the first and most pressing issue would be I guess the inventory situation in the UK. Over the past few weeks has it become any more -- any bit more clear as to what actually drove I guess the miscalculation or the adjustment on the book to physical? And what are I guess in detail the near-term fixes to that?

Let me take a stab at that. I don't think we have any more necessarily any precision in terms of the exact cause. We feel it is several factors. As you know, we buy through distributors in the United Kingdom rather -- contrasted here in the United States where we buy product directly from the manufacturer and put it into our distribution centers.

So as a result with the recent growth of product sales in the United Kingdom I think they are experiencing a lot of the same growth pains that we here in United States experienced several years ago. And part of the factor is going to be either some of the stores, the product that is walking -- coming in the front door, maybe walking out the back door. Some of it may not be that we're paying some of product that we're paying for may not even hit the front door. Or some of it could be the fact that product that is in the salons isn't being accurately counted. It is probably a combination of the 3.

The fact of the matter is we have the full cooperation -- the attention and the cooperation of our United Kingdom salon operations. And we have put a lot of the people from Minneapolis. Norman Knutson (ph), who runs our Trade Secret Division, as well as a couple of the Vice Presidents that deal with the merchandising and distribution of product here in United States have been over to London to help our UK operating people install some controls and some systems.

The finance group is also working with them. So we will try to identify the source of the problem and take some control actions to mitigate it. We're highly confident that this is fixable. I would expect at this point in time that it is not going to take -- we're not going to be able to get it fixed in the next week or the next month. But I would certainly think within the next 6 to 12 months we will have a very good handle on it.

Okay. And just a follow up here. The comps have certainly been just a little soft here. I know you are up against some tough comparisons. But when you look at the performance, of say the batch of 200 salons that you're set to acquire, and you look at that comps, are you see consistency across even the Company that you're looking at to purchase? Is everyone in the same boat? Are there any geographies or I guess salon concepts styles that are performing better than others?

It's amazing. The long hair issue has -- is really across all systems. There is no geographic -- there are no geographic issues or even price point issues. It is something that we have lived through before, and will definitely cycle because very frankly people just don't look as good as they could look if they have that long disheveled hair, especially people over the age of 45.

Kevin Foll with Next Generation Equity Research.

Yes. Just on your kind of long-term targets for both service comps and product comps getting back into that 2 to 4 percent range, can you talk about some of the biggest drivers there? I know obviously this long hair trend is one of the drivers.

Also, you know in my analysis the percentage of the acquisitions -- I guess when you acquire a salon it is typically more mature. And as you start to build out organic growth I know that should help the blended comp with the ramp up in the first few years. Can you give me your expectations of the organic growth versus acquisition growth and that aspect of getting back to that historical comp range?

This year we will add incrementally well over 100 stores more than last year in terms of new builds. And 2006 will probably have the same kind of incremental salon build. That is easier to codify than acquisitions. I mean for obvious reasons. But going forward, Randy pinpointed a 55, 45 ratio and that if anything will probably be weighted towards new builds than acquisitions. But let's not forget there are opportunities to acquire the hair restoration Ma's and Pa's as well as schools. So you have to look at all 3 businesses to make that kind of judgment.

And my estimates is each of those businesses ramp up to close to 5 percent of sales in the next whatever, 3 to 5 year horizon, and that should be a 30, 40 basis point lift to operating margins just from the mix shift. In that what you guys are looking at internally, something like that?

Yes. Without getting too precise as to that, you're absolute right directionally. These are higher margin businesses. And with the growth of that, that will have an accretive effect to our consolidated margin.

And then quickly last -- any update on the business post December? I know the comps kind of fell off in the latter half of the month, and are you seeing a similar trend in January?

The storm was not helping, so January is also flat.

Sharon Zackfia with William Blair.

I don't think you mentioned what the payroll costs were that were rectified. Obviously I would suspect you had some deleveraging on payroll because of the comp, but was there something else occurring?

What ends up happening is that every year in the month of December generally with Christmas, Chanukah, and New Year's, office parties, the revenue builds throughout the entire month. We were very encouraged with early in the month of December, whether it was the first 10 to 14 days. We had very solid same-store sales growth. And as a result we start staffing in the month of December to meet that growing anticipated customer demand.

What ended up happening was after the first 10 to 14 days it was like we hit a wall and we started experiencing some very negative trends. And as you know with the month itself turned out to be negative comps for service. So what we have ended up doing -- the fact of the matter is we had more staff to meet the anticipated customer demand. That customer demand didn't materialize to the same effect. And just like every year we trim back our staffing levels in January. So as I said before, this is not systemic. It has been fixed and I would expect that we will continue to see service margins higher in the future quarters than what we experienced here in the second.

Are there any other factors affecting service margins? I'm just curious if you're seeing wage rates, benefit rates anything like that increase. And what kind of pricing power do you think you have to the customer to maybe pass on some of those costs?

That is a two-part question. With respect to part 1, no increases in costs. With respect part 2, the market determines the pricing. We have probably a 3 percent share of all the service business done in the United States -- well, North America that is. And yet we don't control pricing. And it is difficult in this environment to get price increases through.

So you're not seeing anything on the cost end of labor though?

No.

It was really just a scheduling issue that had to be fixed?

Correct.

Jeff Stein with KeyBanc Capital.

I had a couple of questions on the Hair Club acquisition. Have you seen any integration issues that you may not have foreseen before? And additionally did you have any additional thoughts on the cross marketing that you talked about? And lastly, if you could talk a little bit more about where we are in the hair cycle. It is a 12 month problem or a 2 year problem?

Well, the last question first. We have no idea. But we are in now probably the third year. And I just can't imagine that it will last much longer, but nobody knows. Nobody has that kind of crystal ball. There had been virtually no integration problems at all. It has been extremely smooth, the transition. They -- we have a management team that is totally separate and distinct from ours, and they are located in Boca Raton, Florida. And they are using more and more of our back office facilities, and it has gone very, very smoothly. The second question --?

Across marketing.

Cross marketing. We're taking our time. We have already had several meetings. And I assume within the next 2 to 3 months we will do some experimentation.

Mike Hamilton with RBC Dain Rauscher.

Paul, I was wondering if you could take a little bit of time looking at a 2 or 3 year outlook on how you're thinking about Europe, specifically what you would like to accomplish, how meaningful to the big business model as it stands now Continental Europe is to you? And just kind of update there?

Most of our dollar spend on CapEx as well as acquisitions will be in North America. There is still an outside chance that something will happen in Asia, but it highly unlikely that anything will happen in Asia within the next 2 to 3 years.

The Company-owned operation in the UK is very strong, but we will have relatively modest growth. So -- and we basically sell these franchise on the continent. So we basically see modest growth in Europe. We're not going to put a tremendous amount of additional capital into it. And the UK has performed extremely well over the last 5 year period of time. They have a little hiccup right now, but they will get right back on track. But most of our spend will be in North America.

Thanks. And thanks as well for the detail you have been willing to go to on your segment break out.

You are welcome, Mike. Thanks.

(OPERATOR INSTRUCTIONS). Mike Clascow (ph) with High Grown Partners.

I have just got a question. In terms of when you were talking about the reason for the miss, I think you reallocated some of the product issues in the UK to service and some to retail. And I was just wondering what are the mechanics or how do you track those differently?

Well, we have again various -- we have SKUs and some are allocated to shop, or on the service out of the business, some are allocated to retail. Mike, there is -- not unexpectedly there's a lot of crossover where you'll have shampoo that is sold on the retail shelf that is also can be transferred to the back bar and used in servicing customers. So we try to track based on purchases and the SKU levels that are directly attributed to either shop or service and we compare the respective counts accordingly.

And also you guys talked about school growth potentially being much larger I think than what you guys have already indicated. I'm just kind of wondering if you can maybe elaborate there a little bit?

We're in discussion with a -- with several school owners that have changed the schools. And we're highly confident that we will have $100 million business within 2 years, 2.5 years. Other than that I can't say.

Kevin Foll with Next Generation Equity Research.

As you look at your service margin product margin, which divisions do you think have the most opportunity? And I guess what are some of the initiatives you're doing to capitalize on the opportunity? And then on the beauty school business are there any issues, regulatory issues, or risks that you're looking at that might come up?

The second question first. We are dealing with a Department of Education and we have to be extremely careful. And we're going to spend a bunch of time, effort and money making sure we have the checks and balances in place to mitigate those risks.

Yes, let me just a say, as it relates to maybe what divisions -- are there opportunities for service and product margins. I feel really good, and I have always felt really good, about the controls that we have in place and over maintaining the high margins that we do experience both in product as well as service. 50 cents on every dollar that we bring in goes back out in payroll and related costs. Our operating people are outstanding in managing payroll costs. We buy product better than ever. And even this year with this book to physical adjustment largely attributed to the United Kingdom, I would still say, as we've said in our press release today, that we're expecting our service comps to be better in the future than they were in the second quarter, maybe even a little slightly better than what they were for all last fiscal year.

And I think our product margin rate will continue to maintain a very strong rate. So I don't think that there are a lot of things that are necessarily broken, but the one opportunity, if we want to look at it that way, is to enhance our product margins, primarily our product margins in the United Kingdom. And that is just getting your arms around, strengthening some of the controls and buying product better. And so I would point to maybe that one division.

If there are no further questions. I will now turn it back to Mr. Finkelstein with any closing remarks.

Thank you for joining us. We appreciate it.

Once again, ladies and gentlemen, if you wish to access the replay for today's call, you may do so by dialing 1-888-203-1112, with an ID number of 8983384. This concludes our conference for today. Thank you all for participating and have a nice day. All parties may now disconnect.