RCI Hospitality (NASDAQ: RICK)
Written on Feb. 1st, 2021
Price at time of writing: $38.89
Disclaimer: This report is not financial advice - please do your own due diligence.
Business Overview
RCI Hospitality (NASDAQ: RICK) is a Houston-based owner/operator of 39 strip clubs and 10 military-themed sports bars/restaurants called 'Bombshells'. RCI owns the XTC Cabaret, Club Onyx, Jaguars, Scarlett’s, and Rick’s Cabaret lines of clubs, among others. While most of the clubs are in the Houston area, they also own clubs in MN, NY, NC, FL, LA, IL, and PA. All 10 Bombshells are currently in Houston, but RCI plans to expand and is targeting the Houston, Dallas, and Miami markets for the next 10 Bombshell openings.
The company mainly generates revenue through food and alcohol sales, as well as though cover charges into their nightclubs. The business has high and stable gross margins of 85%. The nightclubs and Bombshells themselves are high-margin businesses; they have EBIT margins of 35% and 22%, respectively.
These margins are enabled by significant barriers to entry. Its clubs are built in high-density areas where zoning laws are becoming stricter regarding the construction of new strip clubs, putting RCI in an attractive position within its competitive landscape.
Investment Opportunity / Thesis
RICK currently trades at $39, and I believe that the stock will be worth at least $80 within 2 years with limited downside risk. The thesis for this prediction is based on the following:
1) COVID allows RCI to resurge as a net beneficiary
2) RCI’s capital allocation will enable it to deliver ROE in the mid-to-high teens and organically expand Bombshells
3) RCI’s is poised to continue growing under a fortress balance sheet and reduced debt load
1) COVID allows RCI to resurge as a net beneficiary
In a pre-COVID world, RCI produced $1.4M EBIT per Nightclub and $1M EBIT per Bombshell per year. As mentioned previously, this comes out to 35% and 22% EBIT margins for nightclubs and Bombshells, respectively.
In the 4Q 2020 (RCI uses a 9/30 FY) earnings call, CEO Eric Langan guided to 10 new Bombshells opening in the next 3 years if they can finance them at appropriate entry prices. Langan has stressed that they only finance a purchase at a max of 4x EV/EBIT, which is an appropriate entry point to deliver solid cash-on-cash returns. Langan expects each Bombshell to cost $2.5M to build, so let's use $3M in our model to be conservative.
Therefore, in FY 2023 RCI should own 39 nightclubs and 20 Bombshells if they solely focus on expanding the Bombshells line. If we simply maintain the EBIT per entity metrics laid out above and assume no top-line growth, RCI produces $50M in EBIT and $70M in FCF in FY 2023. If we allow for EBIT to annually grow at 8% (its four-year pre-COVID CAGR), RCI generates $60M in EBIT and $80M in FCF by FY 2023. We consider this estimate to be a conservative base case scenario given that management has guided Bombshell margins to be closer to the 25% given the amount of restaurant closures in the Houston area. Moreover, we are assuming no growth in the nightclubs segment to simplify our projection with the best available data, which underpins the significant margin of safety inherent in this investment.
The typical Bombshell restaurant is sizeable, with capacity for about 400 to 550 people in the interior, and has large outdoor patios, allowing it to continue operating in COVID even as restrictions tighten.
2) RCI’s capital allocation will enable it to deliver ROE in the mid-to-high teens and organically expand Bombshells
In 2016, RCI’s CEO, Eric Langan, introduced a new capital allocation strategy that changed the direction of the company for the better. The allocation strategy is remarkably simple: RCI buys back its stock whenever it is trading at >10% FCF yield. Otherwise, it will either: a) acquire existing nightclubs or b) continue to expand its Bombshell line. The goal for either nightclub acquisitions or new Bombshells is to generate 25-33% annual cash-on-cash return.
I am are confident in Langan’s ability to continue reducing the share count, as outstanding shares have decreased from 10.4M in FY15 to 9.0M as of FY20. This outstanding share count equates to a $8 FCF per share given our forecasts for FY23. Given today’s share price of $39, this represents a relatively short payback period for the proven durability of this company.
3) RCI’s is poised to continue growing under a fortress balance sheet and reduced debt load
As of 9/30/20, RCI has $143M of debt, at a weighted average interest rate of 6.5%, and $15M in cash. Approximately 60% of the debt load is secured by RCI’s real estate. In the 4Q20 conference call, Langan hinted that they just filed to refinance their debt load towards $115M at 5-5.5% interest rate. The new refinancing will reduce RCI’s current debt service by a third, from $14M a year to $9.2M. This refinancing adds $5M of yearly FCF to our projections with zero additional work, further improving RCI’s financial standing.
Management / Insider Ownership
Eric Langan has been the President, CEO, and Chairman of RCI since 1999. I am confident in his ability to lead the company, evidenced by his recent shift in the company’s capital allocation strategy.
I am also comfortable with Langan's incentives being aligned as he owns 7.85% of all outstanding shares, making him the second largest shareholder behind hedge fund ADW Capital, which currently owns 10%.
RCI does not currently pay using stock options, further decreasing equity holders' risk for dilution. In fact, since Langan embraced his capital allocation plan, the share count has continually decreased, and I expect it to continue to do so in the future.
It is also worth noting that roughly 6% of RCI’s float is held short at the time of writing. This has declined from a 10% short interest in October 2020.
Why now?
RCI's $475M EV does not properly reflect the durable cash-generating abilities of RCI on a per-share basis. RCI is unduly pegged as a sin-stock that has been deeply hurt by lockdowns, when in fact it was FCF positive (+$13M) in FY20. Eric Langan lays out the point clearly in the 3Q20 conference call:
“But what they don’t understand is, we’re in the real estate business. We’re in the restaurant business. A lot of businesses comprise that adult entertainment business. Our real estate equity has been a huge resource for us since 2017.”
Given our conservative projections in which RCI organically generates $80M of FCF by FY 2023, an EV of $950M (a rough 12x FCF multiple) is a more accurate portrayal of the underlying business. This equates to roughly a double from today’s stock price.
Where could we be wrong?
Bombshell expansion flops
Mitigator: Eight of the ten Bombshells are currently based in the Houston area. The other two are in Austin and Dallas. The ones in Houston are built in completely different residential-commercial parts of the city since they are on average 25 miles away from each other. They are built alongside Houston’s major highways, its inner and outer loops, to drive customer engagement. Bombshells has established its name in Houston due to its strong military presence, so there is a risk that the expansion into Miami and Dallas does not generate sufficient traction. RCI already operates two clubs in the Miami area and two clubs and one Bombshells in Dallas, so there are boots on the ground already to ensure that operations run smoothly.
A secular decline in strip club attendance fueled by porn increase
Mitigator: Annual revenue at US strip clubs has grown at a 2.3% CAGR from 2016 to 2021, according to a report by IBISWorld. More importantly, the number of strip clubs in the US is declining, which drives traffic towards RCI clubs, which are larger and well-established. Post-COVID, I expect the smaller and less capitalized clubs to eventually close or sell out to RCI, as Langan laid out:
“Sellers are calling us, brokers are calling us, and we’re looking at the deals on a deal-by-deal basis and seeing what fits best for us. We’re sticking pretty close to our three times EBITDA unless it’s a special situation, special license club or limited competition market or very special market where we might expand closer to four times.”
Even if there is a significant decline in RCI’s strip club attendance, the Bombshells line is insulated from this risk being in the restaurant business.
Dancers demanding to be classified as employees as opposed to independent contractors under the Federal Fair Labor Standards Act
Mitigator: As listed in the 10-K, “All employees and independent contractors sign arbitration non-class-action participation agreements where allowed by federal and state laws. None of our employees are represented by a union.” This of course, may change if there is a federal mandate, but we view this event as unlikely, especially given Uber and Lyft’s recent win on Prop 22.