|Shares Out. (in M):||10||P/E||8.4||8.2|
|Market Cap (in $M):||195||P/FCF||7||5.7|
|Net Debt (in $M):||144||EBIT||38||40|
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RCI has been written up before, but it’s less expensive today, even as the company has substantially grown its earnings. That reflects a number of negative developments which I’ll address. The earlier write-ups describe the business but the quick recap is RCI owns 37 strip clubs, mostly in high density urban areas where it’s hard to license new strip clubs, creating a barrier to entry. The company also launced the Bombshells ‘Breastaurant’ chain in 2013 and now has eight locations (soon to be nine). In most cases RCI owns the land affiliated with both its clubs and restaurants – 7 of its clubs and 2 Bombshells are leased.
I view the core strip club business as attractive because it is highly cash generative and high margin, with club operating margins above 30%, and because the company can reinvest that cash at high ROIs in new clubs. That’s because there aren’t a lot of natural buyers for high value strip clubs, so the sale multiples tend to be low, typically around five times EBITDA inclusive of the underlying land. Regarding the market for clubs, in many cases these businesses are owned by individuals who are aging and want to cash out. A well-run club typically earns anywhere from $1 to $3 million depending on location, so sale prices would range anywhere from $5 to $15 million. Banks typically don’t want to lend to strip clubs and the business poses reputational problems for private equity, making RCI one of the few well-funded buyers.
A reasonable question given those dynamics is why the company hasn’t grown faster. Revenue has roughly doubled over ten years, a 7% CAGR, not terrible, but not what you’d expect given the high ROI opportunities. Part of the answer is that the company made a $21 million value destroying acquisition of Scores-Las Vegas in April 2008 which took several years to recover from. Ultimately the company exited that club and wrote off most of the cost. I think the company learned from that mistake, and its subsequent acquisitions have been, on average, far more successful. However, it’s also the case that a small percentage of the company’s clubs fail over time, so the all-in ROIs are in fact somewhat lower than the mid-single digit EBITDA multiples would suggest.
That said, RCI has forecast free cash flow of $26 million this year, and has earned $20 million through its first two quarters, so even with the fourth quarter being seasonally weak, it should end up closer to $30 million in free cash flow. That implies about $3 per share free cash flow, or a 15% free cash flow yield at the current price. Even if the ROIs on new investment are somewhat lower than the 20% suggested by 5x EBITDA multiples, at its current valuation the stock is pricing in negative growth, which I think is far too pessimistic. That brings me to the reasons for the discount, which are:
1) The company voluntarily changed accountants in 2017 from a regional Texas firm to BDO. BDO has been more stringent on reviews, controls, and disclosures, leading to two delayed 10-K filings in 2017 and 2018. The process was likely exacerbated by the company’s decision to implement a new ERP system during this period.
2) In mid-2018 a post on the Corner of Berkshire and an article on Seeking Alpha revealed (after some commendable sleuthing) that RICK’s CEO, Eric Langan, as well as one of its executives (Ed Anakar) were a part-owners of a strip mall JV (Tannos Land Holding) with Louis Tannos, the owner of Tannos Construction. Tannos has been the general contractor on a number of RCI Bombshell projects, as well as a couple of club remodels. For background I recommend reading this Seeking Alpha article https://seekingalpha.com/article/4209165-rci-hospitality-troubling-relationships-reinforce-short-thesis. That article put pressure on the share price at the time. Then on May 10 this year the company indicated it would be delayed filing its 10-Q due to an SEC informal inquiry into the allegations. Note that after a strong first quarter reported this February RCI’s shares traded to $25 and then shortly after began falling despite no public information. I believe short sellers and some other parties may have anticipated interest by the SEC, resulting in the steady price decline.
3) In late 2018 and into the current period, Bombshells' operating results weakened due to a variety of factors, including highway construction which interfered with restaurant access, a highly publicized drunk driving incident and ensuing attempt by a local DA to close the location (eventually dismissed but location was temporarily closed and had to rebuild traffic), and a long stretch of rainy weather which interfered with the restaurants’ patio business. Bombshells' results are still recovering from these issues, and while they should be solidly profitable later this year, there is a plausible criticism that the Bombshells restaurants have been a poor use of capital.
4) The business is somewhat cyclical. Strip clubs earn about half of their profit from VIP rooms, where patron/patrons spend time privately with dancers. VIP rooms typically rent for several hundred dollars an hour, with the proceeds split between the club and dancer, and are the highest margin revenue source for the club. As a high-ticket item, they are susceptible to economic weakness, and create an element of cyclicality and market sensitivity. RCI comps rebounded fairly quickly after the great financial crisis, although its large presence in Texas may have helped given oil price stability at the time, so depending on the geographic areas of weakness in the next recession it could be more impacted.
5) Secular concerns around strip clubs including competition from internet pornography, changing cultural norms, zoning and other legal risks, potential for prostitution and sex trafficking.
Most of these issues are related. A big part of the Tannos critique has been that the Bombshells investments were ill-advised and that the use of Tannos Construction was conflicted by the shared investment in the real estate JV. Based on the history here and knowing management I think that’s unlikely but more on that later.
First, I do think there is a legitimate question as to the viability of the Bombshells concept. Inclusive of owned land, a Bombshells costs about $4.5 million to build, with annual target earnings of $1 million, so a low 20% ROI if all goes well, but of course all does not always go well. Since beginning the concept in 2013 the company has invested (inclusive of debt) about $46 million in Bombshells, more than half of that over the last eighteen months. To date, Bombshells have earned roughly $10 million in operating income. In fairness, that $10 million has been largely earned on the first $20 million of investment, so that ROI looks ok, but it remains to be seen whether the $30 million invested in the last eighteen months will pay off. Note that more than five million of that investment was for surrounding land parcels which the company will sell, so net of those sales the eighteen-month investment will be in the 20s and the all-in investment in the 40s. Even so, it’s looking like the ROIs here are (somewhat predictably) disappointing, I’d guess mid to high single digit. If that’s the case, the company will likely stop expanding the concept (they certainly won’t continue investing at the same rate) and might consider a sale if they could get a reasonable valuation.
Regarding the suggestion of some quid pro quo with the Tannos partnership, I believe that is highly unlikely. My impression from prior conversations with with CEO Eric Langan is that RCI is his life’s work and his primary store of wealth (he owns 0.7 million shares or about 8% of shares outstanding). He does not take egregious compensation or share comp, despite substantial board influence (in fact, the management of shares outstanding here over the years has been unusually good, and through buybacks this is a company that could realistically reduce shares outstanding by more than a third in the years ahead). The Tannos contracts were cost plus and reviewed by auditors, the cost to build a Bombshell, taking into account land value, is comparable to the cost of a Chile’s or other chain restaurant. There is nothing to suggest wrongdoing.
I do think the company made a mistake in not disclosing the Tannos co-investment given Tannos was a vendor. I believe that may be the primary issue of interest to the SEC, and would expect a settlement where the company agrees to additional controls for related party transaction review and disclosures. RCI has already hired outside counsel to review the transactions and to help implement improved controls. I believe this proactive action will help to achieve a reasonable settlement with the SEC in the months ahead. Bigger picture, I believe that Rick’s has historically been run more like a family business and is now adjusting to becoming a more scrutinized pubic company.
What if the Tannos issues are worse than I imagine? While again I view this as very unlikely, in a worst case scenario if there were some evidence of actual wrongdoing, it could lead to a shakeup in management at the SEC’s insistence. There are several longtime insiders at the company who could take over day to day management, and potentially an outsider with more public market experience would be hired for further oversight and to interact with the street. I don’t think this would lead to a long-term value impairment, although it could lead to near term downside in the stock. However, I see valuation providing a margin of safety here. At $15, or roughly down 25%, the stock has a free cash flow yield north of 20% with limited capital needs. The company could buy back close to 20% of the stock a year. I think that means that while the stock can trade to that level in the short term, its unlikely to stay there, barring a real deterioration in the core business.
Which brings us to the business itself. Despite all the cultural changes and the emergence of free internet pornography, strip clubs remain an excellent business. RCI pre-announced its second quarter operating earnings, and those numbers would indicate the strongest March quarter club earnings in the company’s history, after the strongest December quarter three months ago. Maintenance capital on clubs is low, roughly $3 million on $46 million of EBITDA, so cash conversion is high. The company should generate roughly $30 million of free cash flow before growth spend this year, which will finance the completion of the Bombshell’s construction, as well as support some share repurchase. Absent other uses for capital, I’d expect the company to repurchase about $2 million of shares a quarter at current prices, representing annual retirement of about 4% of the shares, with the balance of cash flow going to debt paydown and building up a store of funds for acquisitions.
On the broader issue of whether people will keep going to Strip clubs, there are two key customer sets, groups of younger men who go to clubs as groups and men (typically older) who develop a relationship with a dancer that that fosters recurring attendance. For these men, the dancers provide companionship that isn’t substitutable online. Regarding the potential for illegal activity such as prostitution, it is in the corporation’s interest to do everything it can to operate legally, given the costs of any illegal activity for outweigh any benefit derived. RCI has been operating clubs as a public company for roughly twenty years and has not to my knowledge had a club closed for illegal activity. From time to time clubs do become unprofitable and are closed, so it is reasonable to assume some long-term attrition in same store club count which should be more than offset by acquisitions. That said, in recent years management sold or closed its worst performing clubs, so I would expect fairly stable same store club count over the next few years.
Filing of 10-Q, improvement of internal controls and resolution of SEC inquiry, improvement of Bombshells earnings, share repurchase, club acquisitions.
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