VCG Holding Corporation Q3 2008 (Quarter End 9/30/08) Earnings Call Transcript

Nov.25.08 | About: VCG Holding (VCGH)

VCG Holding Corporation (NASDAQ:VCGH)

Q3 2008 Earnings Call

November 10, 2008 11:00 am ET

Executives

Gerrard Lobo - Senior Account Executive - The Equity Group, Inc.

Troy H. Lowrie - Chairman of the Board, Chief Executive Officer

Courtney Cowgill - Chief Financial Officer, Chief Accounting Officer, Treasurer, Secretary

Analysts

Marco Rodriguez - Stonegate Securities, Inc.

Eric Wold - Merriman Curhan Ford & Co.

Steven Martin - Slater Capital

[David Fore - Montgomery Street]

[Scott Newsbon - Brautlin Capital]

Operator

Welcome to the VCG Holding Corporation third quarter 2008 conference call. Today’s conference is being recorded. At this time I would like to turn the conference over to Mr. Gerrard Lobo from The Equity Group.

Gerrard Lobo

Welcome everyone and thank you for joining us on VCG Holding’s third quarter 2008 conference call. Our speakers today will be Troy Lowrie, Chairman and Chief Executive Officer, and Courtney Cowgill, Chief Financial Officer. If you haven’t downloaded the company’s slide presentation which will be referenced during this call, you can do so now at our website at www.vcgh.com. The presentation is located in the Investor Relations section under Events & Presentations and labeled Third Quarter Presentation.

Before we get started I would like to remind everyone that certain statements made during the course of this conference call, especially those that state management’s intentions, hopes, beliefs, expectations or predictions for the future are forward-looking statements. It is important to remember that the company’s actual results could differ materially from those projected in such forward-looking statements. Additional information concerning factors that could cause actual results to differ materially from those in the forward-looking statements are contained in the company’s annual report on Form 10K, copies of which may be obtained by contacting either the company or the SEC.

By now you should have received a copy of the news release which was issued this morning before the market opened. If you have not received a copy, please call [Tanisha Bradley] at 303-934-2424 or my office at 212-836-9610 and either one of us will send you a copy.

I would now like to turn the call over to Troy Lowrie.

Troy H. Lowrie

I would like to welcome those of you joining us by the telephone and the Internet. I will begin by giving everyone a brief overview of our operation and activities during the quarter. I will then discuss our opportunities and strategies for the near and long term before opening the floor to any questions you may have.

If everyone could please go to page 3 of our presentation. As a quick introduction to those of you that may not be familiar with our story, VCG Holding is a growing and leading consolidator and operator of adult nightclubs. As the slide illustrates, in 2002 our business model has been acquisition centric.

We currently own and operate 20 entertainment nightclubs in 10 states. Unlike others in our space, our growth strategy is centered on the concept of regional clustering where we can operate multiple locations in smaller cities. There is little risk of cannibalization because our clubs operate under different brands and they are tiered A, B or C which denotes for example the location of the venue relative to high traffic areas and amenities offered.

Our most recent acquisition was Imperial Showgirls in Anaheim, California which we consummated the end of July. The third quarter of 2008 contains two months of the contribution from Imperial Showgirls which was accretive to earnings. We continue to evaluate acquisitions that we believe fit into our target profile and which will be accretive to earnings. I will touch more on our acquisitions strategy later.

Please turn to slide 4. Slide 4 gives a breakdown of our revenue by venue type A, B and C. As you might expect our A venues which are larger amenity-rich facilities contribute more in ways of revenues but our B and C locations generate higher EBITDA margins because of their lower overhead.

The pie chart on the right illustrates our revenue breakdown. As you can see service revenue comprised a much greater percentage of this total pie for the nine months ended September 30, 2008 as compared to all of last year. The reason is the implementation of a bracelet/wristbands system for access to other parts of the club for table dancing, table side massages and suite rentals. All of these items that we added come at 100% profit margin for the company.

Moving on to slide 5. We were pleased with the performance in the third quarter of 2008 highlighted by record revenues of $15.2 million, up nearly 40% from the third quarter of 2007. We attribute this rise in year-over-year revenue mostly to successful acquisition and integration of high quality clubs we have acquired since September 30, 2007. The third quarter of 2008 also marked the third consecutive quarter of same-store sales growth which represents 10% of the total increase in revenue year-over-year.

You’ll see that we incurred exceptionally high operating expenses in the third quarter of 2008 which Courtney will detail in her remarks. This affected operating and net income for the third quarter but I again want to stress that we were very pleased with our results.

Our GAAP EPS for the quarter was $0.10 based on approximately 18.4 million fully diluted weighted average shares outstanding taxed at a rate of 32.2%. This compares to the diluted EPS of $0.19 for the third quarter of last year based on approximately 17 million fully diluted weighted average shares at a tax rate of only 3.2%.

If you could please turn to slide 6, the History and Growth of Profitability. Slide 6 gives clear representation of our growth in revenue and net income over the past few years as well as a quarter-over-quarter comparison. You’ll see that this growth has been driven by acquisitions. Over the past three years we have grown from six clubs in three states to 20 clubs in 10 states. The pipeline for acquisitions is strong and we haven’t been affected by the economy. We are positioned to be able to close on one more acquisition by year end if we choose to.

Please turn to page 7. The next slide shows our EBITDA dollars and margins. Even with the high legal and compliance expenses experienced in the third quarter and the one-time hits from the second quarter, our EBITDA margins remain very strong.

Please turn to page 8. Balance Sheet Highlights. You’ll see here that we ended the quarter in sound financial position. While we are discussing the balance sheet, one of the things I want to mention is our negative working capital. We understand that this might be an impediment to attracting new investors for the simple reason that if they run their initial screens and negative working capital pops up, they will not go further to investigate. Courtney will discuss our strategy for improving our negative working capital.

Please turn to page 9. Before I turn the call over to Courtney, I would like to discuss free cash flow. Free cash flow remains to be one of our strong points and will benefit us as we seek to close on further acquisitions or seek to clean up certain aspects of our balance sheet. Based on the current sources of financing combined with free cash flow, we believe we are in a position to execute on our plans for acquisitions for 2009.

With that I would like to turn the discussion over to Courtney for a review of our financials for Q3 and the first nine months of 2008. I will then go back to our slide presentation to discuss our strategy and further opportunities.

Courtney Cowgill

Hopefully you’ve had a chance to read our press release and to review the associated 10Q. As Troy noted we had another great quarter in terms of revenue growth and same-store sales but we also experienced some unusually high expenses which affected net income and earnings per share. I would like to cover those items which led to the higher operating expenses in greater detail before summarizing our numbers for the quarter and first nine months of 2008.

As Troy mentioned total revenues increased nearly 40% from $10.9 million in Q307 to $15.2 million in Q308. Same-store sales increased 3% from the last quarter and 9% from the same quarter in 2007.

Operating expenses for this last quarter were $11.4 million compared to $6.9 million in Q3 2007. That’s an increase of 61%. Reasons for that increase include: Salaries and wages increased by $1.2 million or 58% because of the club acquisitions; i.e. more clubs equal more employees. We also had an increase in the tipped minimum wage and in addition the company president joined our payroll in Q4 2007 and our CEO joined our payroll in Q1 of 2008. Both of those made our ’08 labor higher than our ’07 numbers.

Professional fees increased almost $900,000 this quarter because of increased legal fees due to lawsuits that are written in the Q, SOX compliance work that we’re doing right now, and corporate governance which includes updating our charters, policies and Board directives and the improvements we’ve made to the company’s financial infrastructure.

The increase in other expenses of $1.2 million included increases in utilities, i.e. more clubs and a dramatic increase in energy rates, increases in repairs and maintenance to update and refurbish the existing clubs, and expenses incurred in improving the newly-acquired clubs.

We manage salaries and wages with a percentage based on revenue so these expenses will flatten out in 2009 with the exception of future acquisitions. I expect to see the legal and professional costs in ’09 to decrease as well as we complete the governance and infrastructure projects. I’m also projecting that most of the existing lawsuits with the exception of the Texas patron tax to be finished in ’09 as well.

Charges included in the other expenses tend to grow as the costs grow and will stay reasonably proportionate.

Accordingly, income from operations declined by about $221,000 due primarily to the higher operating expenses that I just mentioned. Net income for the quarter was $1.8 million or $0.10 per diluted share based on approximately 18.4 million fully diluted weighted average shares outstanding and taxed at a rate of 32.2% if you compare that to net income for third quarter 2007 at $3.1 million or $0.19 per share based on a 17 million fully diluted weighted average share outstanding impact at the rate of only 3.2%.

If you apply our 2008 effective tax rate of 32.3% to Q3 results in ’07, your net income and earnings per share would have been $2.2 million and $0.13 respectively. The 2007 effective tax rate for the quarter was only 3.1% because of NOL carry-forwards. Those carry-forwards have been used now for ’08. I think those percentages and that application makes those numbers much more comparable.

Now I’ll quickly go over our performance for the first nine months of ’08 compared to the same nine month period last year. Total revenues for the first nine months increased from $26.8 million in ’07 to $43.2 million in ’08, up 61%. Of that 61% increase, same-store sales consisting of nine clubs represented 10% of that increase.

Operating expenses for the first nine months increased from $18.9 million in 2007 to $33 million in 2008. The reasons for that year-to-date increase include:

One. Salaries and wages increased by 76% and I pretty much discussed that.

Credit cards and bank fees have increased by 106%. A lot of that is because of the increased number of clubs and we’ve seen a substantial increase in credit card usage. We are starting a new program now that should reduce our fee per credit card charges; and just as a note, we don’t lose very many charge-backs. We manage charge-backs very closely.

Professional fees increased 45% for the nine month period mostly because of litigation costs described in the Qs and the costs that we’ve already disclosed relating to the change of CFOs in Q1 and Q2 of 2008.

Other G&A expenses have doubled when compared to 2007 because of repairs and maintenance, utilities, employee training and previously disclosed write-offs due to asset sales, robberies and due diligence costs. All of these are noted in the Q.

The good news is that operating income for the first nine months increased from $7.9 million in ’07 to $10.2 million in 2008. That’s an increase of 29.4%. Net income during the first nine months of ’07 was $5.9 million or $0.44 per diluted share taxed at a rate for the year of 7%. If that same 2007 income were taxed at the 2008 rate of 32.9%, the period also included approximately $0.02 per share in unusual one-time expenses incurred during the second quarter of 2008 that we’ve already told you about.

Operating cash flow improved to $4.9 million for the three months ending September 30, 2008 which is up $2.7 million from June 30, 2008 and $1.8 million at 3/31 of this year. Operating cash flow for the first nine months of 2008 was $9.4 million, up 20% from the $7.8 million in the first nine months of 2007. I want you to note that our operating cash flow continues to increase dramatically by quarter. We don’t anticipate that to change.

At the nine months ended September 30 of ’08 we had borrowings of approximately $38 million. Of that, $7.3 million is classified as current or due within the next 12 months. The majority of that current debt can be refinanced for another year at virtually identical terms if that becomes our choice. That choice would free up operating cash for more acquisitions. Alternative B would be to use the operating free cash to pay down this debt over the next 12 months. That ultimate decision will be based on the financial market stock price and we continue to evaluate it constantly.

We are still looking for a revolving line of credit to consolidate the smaller loans. The falling economy, turmoil in the market and a tightened credit have obviously not helped our cause. We’ve had several offers from investment banks and private lenders to offer us that line but at a cost of warrants or stock. We don’t need to accept that type of offer and we continue to look. I have complete confidence that someone we’ll recognize the huge value of our positive cash flow and will be willing to lend to us based on that. We were able to obtain an additional $6 million of new debt in Q3 even in the time of rough financial markets and tight credit.

Our negative working capital is a result of the borrowings in ’07 and early 2008 to finance our acquisitions. The average working capital calculation of current assets minus current liabilities does not take into account free cash flow. It’s almost an optic issue for you as an investor.

The casual reader of our financial data would make a quick but incorrect assumption that we don’t have enough cash to pay our short-term obligations. But if you look at our cash flow statement and our calculation of free cash flow, that shows something that’s different. This is an issue that we’re discussing in our decision for debt buy-down versus acquisitions. We evaluate it every time a note comes due and the lender offers to refinance at the same terms.

Cash and cash equivalents as of September 30 ’08 was $2.8 million compared to $3 million at the end of the year. Our use of cash for the year included paying down a debt by $1.7 million for the quarter and $3.6 million for the year-to-date. We’ve also had maintenance capital expenditures for the third quarter of $261,000 and approximately $1.3 million for the nine month term.

Now I’m going to turn the call back over to Troy for a review of our current opportunities and strategies.

Troy H. Lowrie

If everybody can turn to page 10 of the slide presentation at this point, it’s kind of a summary moving forward. VCG will still grow through acquisition. It’ll target more regionally located stores that work with our clustering strategy and will maintain a market-leading position in those clustered markets. We’re looking for stores that do at least $4 million in annual revenue with at least 35% EBITDA margins. It absolutely must be accretive and at our normal multiple of EBITDA of 3 to 4 times. These deals will come with seller financing.

VCG will continue with same-store increases. We will keep developing a high level of repeat business and customer loyalty. We’ll develop new revenue streams similar to the wristbands and backrubs and suite rentals that we implemented already. We will keep implementing best practices and we will continue to train what we think is the best management team in the country.

The opportunities moving forward are that our strong cash flow will allow us to choose from the following: Growth through accretive acquisitions with a strong pipeline that comes with seller financing, more accretive share buy-backs which we’ve just done recently, and also what Courtney talked about on accretive debt reduction. Our strong cash allows us to have many opportunities that other companies right now don’t have and we’re very positive about that.

At this point I would like to open the call to questions and answers.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Marco Rodriguez - Stonegate Securities, Inc.

Marco Rodriguez - Stonegate Securities, Inc.

I wonder if I could ask kind of a high level macro environment question. If you could provide a little bit more color by your different clubs, what kind of impacts are you seeing right now?

Troy H. Lowrie

What we’ve seen is in our A level clubs, the very upscale clubs, a decrease in the big spenders. We don’t have that person who’s spending $2,000 or $3,000 in a night as often as they used to. But what we’re seeing is about a 10% increase in the B and C model where we’re getting more frequency and some higher ticket averages from the blue collar guy. So we’re still getting our overall comp store increases just in a little bit different way than we did a year ago.

Marco Rodriguez - Stonegate Securities, Inc.

Looking at the map you provided on slide 3, are there particular regions that are performing a little bit better or not so much?

Troy H. Lowrie

I really couldn’t break out one specific market that we’re concerned about. Everything’s performing pretty well. There are some clubs that are performing better than others but as a whole I honestly can’t say that we’ve felt an economic impact except for the real big spenders in the A model.

Marco Rodriguez - Stonegate Securities, Inc.

If you could provide a little bit more color in terms of the acquisition strategy. Obviously part of your strategy is this clustering aspect. I was wondering if you could possibly provide a little bit more information as far as what regions you might be most interest in acquiring more clubs in?

Troy H. Lowrie

Right now we’re one off in California with Anaheim. We’d like to develop the California market. We’ve been in Indianapolis for over 20 years now without a second store. We’d love to have a second or third store in Indianapolis. There are a few stores we could get in possibly Minneapolis. Obviously Miami is a market with 30 or 40 clubs that we’re one right now. So there are a lot of good opportunities.

Although I think this industry’s recession proof, I also think there is some fear in some of the sellers out there that things might not be as good as they used to be. I truly believe that we’re going to get some better opportunities out of the poor economic times that possibly you could buy things at a lower multiple, we could get better financing from the sellers than we thought, so

I think it’s going to open up some opportunities. There is a good pipeline out there. We’re only one of two places you can go if you want to sell a club and our strategy of clustering doesn’t really overlap with our competitor’s strategy for growth. So we’re really the one-stop shop for that second and third club in existing markets that we’re in.

Marco Rodriguez - Stonegate Securities, Inc.

You mentioned in your prepared remarks that there was a potential acquisition out there if you so choose to close it. Could you provide some more color in regard to that? It was kind of an interesting comment.

Troy H. Lowrie

We always keep the pipeline full. We manage them through contracts, through liquor licensing, through contingencies that allow us to pull the trigger when we’re ready to pull the trigger. Right now it’s tough to think that you’re going to acquire a store at a three to four multiple one-year trading at less than that, so right now with Courtney on board and this is her first full quarter, we’re very happy. The second quarter she was around for two weeks before then I think. So she’s really had a chance to jump in and work with me on strategy and we’re really just sitting back as a company and looking at all the opportunity we have.

We have three very easy ways to be accretive by $0.05 or $0.06 at least next year just through debt reduction or share buy-back or pulling the trigger on a couple of these clubs in the pipeline. We’re always managing this pipeline and when we’re ready we’ll do that.

Marco Rodriguez - Stonegate Securities, Inc.

Should I infer from your comments there that it’s a valuation question as far as you pulling the trigger?

Troy H. Lowrie

I think it’s a market condition situation. Obviously if our stock drops any lower, right now we believe around $2.50 it’s more accretive to buy our stock than it would be to acquire. We have some 14% debt on the books that over the course of next year it could be more accretive to pay down the 14% debt than to acquire. But in these economic times if these sellers become more motivated to sell and the economy is scaring them, we could have an opportunity to possibly buy a 2.5 to 3 times EBITDA which would make those acquisitions seem more appealing. We’re in a pretty unique position to whatever we do we would make a good choice.

Marco Rodriguez - Stonegate Securities, Inc.

If you could comment a little bit in regard to the acquisition landscape utilizing seller financing versus equity. Are you seeing a change in the tone from the potential targets? Anything you can kind of provide there?

Troy H. Lowrie

No. We’re still seeing a strong pipeline. It’s our criteria that whoever we do buy will be at a favorable multiple to us and favorable financing to us. We really get to drive the sale. There are so many stores out there; 3,800 stores in America. We own 20 of them. [Ricks] owns 19. There’s just a lot of opportunity. We’re going to buy things on our terms.

Operator

Our next question comes from Eric Wold - Merriman Curhan Ford & Co.

Eric Wold - Merriman Curhan Ford & Co.

A follow-up question on the very last one of the last caller. On new acquisitions assuming seller financing, is there a level? You’re buying a club for X dollar amount. Does some percentage of X need to be seller financing to get you interested or does it just vary on the deal?

Troy H. Lowrie

It’s a function of multiple of EBITDA. Right now it’s 50/50. Under a model that we presented in the second quarter we could use the quarterly free cash flow and 50% seller financing to do three or four clubs in 2009. We do have those capabilities.

Eric Wold - Merriman Curhan Ford & Co.

An economy question. Let’s assume no new clubs, nothing gets acquired for whatever reason in the next six or 12 months and the economy doesn’t get any better and maybe doesn’t get any worse but stays where it is, what would happen within the existing clubs? Is it a level of cost-cutting you could do? Do you see more marketing costs to drive people there? Is that not a good strategy in the climate that exists or is it more of just moving the best practices from each club that work, the backrubs or the wristbands, from club to club, there may be because they’re performing worse than average? What are the strategies for existing clubs?

Troy H. Lowrie

We still haven’t realized the full value of the wristband programs or the backrub programs and the suite rentals. We’re still training the rest of management. We’re taking management from clubs that do well to help teach management at clubs that haven’t fully implemented it yet. We haven’t realized all those revenue sources yet but we continue to look for new revenue sources also. I still think there are still same-store increases in the future based on what we’ve already implemented.

It’s hard to answer that question. We really haven’t felt an economic impact yet. We’re continuing business as usual. We believe that the sale of alcohol being 67% of what we do will get us through just like liquor has gotten us through poor economies in the past.

What we find is that there are more beautiful girls that come out in a poor economy. We’re staffed better than we’ve been staffed in a long time. The person that might have lost their $50,000 a year secretarial job is now a gorgeous entertainer for us and with that brings her own clientele of people that want to see her. We have the fall-in-love factor where each girl can bring 10 to 20 people out in a given week. So as long as we have quality and quantity of girls, marketing and anything we can do to impact the economy won’t work. But as long as we have that quality and quantity; and we do have that right now.

Operator

Our next question comes from Steven Martin - Slater Capital.

Steven Martin - Slater Capital

Most of your expenses with the exception of salaries and wages were pretty in line. You detailed a lot of things about legal and professional and other. Courtney, could you give us an idea of as we go into the fourth quarter and next year where those numbers might shake out on a run rate basis or on a quarterly basis? Basically how much is recurring versus non-recurring?

Courtney Cowgill

When I had mentioned earlier during a little bit of my prepared presentation, I talked about what I thought would happen in terms of what was going to be flat. Salaries and wages for example are going to be flat. They’re going to go only as our clubs increase. If we buy another club, our salaries will go up. For repairs and maintenance we’ve done a lot of that right now. I think the clubs and I’m looking at Troy for concurrence on this are in pretty good shape. I think that number will actually drop in ’09 versus ’08.

Steven Martin - Slater Capital

That’s in the other line?

Courtney Cowgill

That’s in the other line. Correct. It’s amazing how much utilities have hit us. I was surprised utilities seem to be our largest line item individually in the other category. That one’s a little harder to maintain because of course we pay the same energy increase that everybody else does.

Steven Martin - Slater Capital

Although those have come down of late.

Courtney Cowgill

Yes. My crystal ball’s a little foggy on the energy. We’re working now to get our credit card costs down. I think we’ve got a new plan that comes in place so you’ll see a reduction in banking fees.

You will see a reduction in legal. We’ve done a lot of work right now in cleaning things up. We’ve done a lot of work now in the whole financial infrastructure. We’re finishing our SOX compliance so that project will be done for this year and of course this is a year where it’s higher for SOX work than it will be for 2009 so I think you’re going to see some of that cost go down. As we get good solid control over our books I think you’ll see the consultancy bills go down. So I think you’re going to see a lot of those costs going down in ’09.

Steven Martin - Slater Capital

Clearly if the numbers of acquisitions are substantially less, the legal and professional related to that [inaudible] would be?

Courtney Cowgill

Correct.

Steven Martin - Slater Capital

The other category has grown to be sort of the third largest or second largest item on the P&L. Maybe it makes some sense to take some of the recurring kinds of things in there like utilities and separate those out so that the true other shows up as other?

Courtney Cowgill

Yes. We’ve talked about that and it’s kind of my intent to either do that as a part of the filing of the 10Q at year end or just as a new program of disclosure in ’09. But I’m looking at that too because those are the same questions that I keep getting. If I keep getting the same questions, then I should just put it as a line item in the detail.

Steven Martin - Slater Capital

And I would propose to you that utilities are not an other expense. They’re sort of like charge cards and taxes and permits. They’re sort of a recurring. They should be reasonably routine.

Courtney Cowgill

And so should repairs and maintenance.

Steven Martin - Slater Capital

Right.

Courtney Cowgill

We will make those changes.

Steven Martin - Slater Capital

Troy, the Anaheim club. How much of that was in the quarter and is there a seasonality to that club that is different than the others?

Troy H. Lowrie

There is some seasonality but we’re buying it in the off season. It still produced about $450,000 of the revenue for the quarter. Courtney, do you have the exact income number that Anaheim produced?

Courtney Cowgill

Not sitting here with me.

Troy H. Lowrie

We don’t have the exact number. We know it was very successful. The first two P&Ls I looked at were comparable to what we had estimated. The fourth quarter’s going to have the full impact of Anaheim in it.

Steven Martin - Slater Capital

Can you give us an idea of what Anaheim would have looked like if it had been included for the full quarter?

Courtney Cowgill

If you pull the Q -

Steven Martin - Slater Capital

I just printed it while we were on the call.

Courtney Cowgill

If you look on page 9 of the Q, it shows what it would look like if Anaheim had been included. So it’s on page 9.

Steven Martin - Slater Capital

What’s your idea for tax rate for ’09?

Courtney Cowgill

It’s going to be high. Honestly we’re going to be fully taxed in ’09.

Steven Martin - Slater Capital

I guess the NOLs are gone.

Courtney Cowgill

The NOLs were gone the first quarter of ’08 so I’m looking at down 37% tax rate. We’re going to have to do some significant tax planning in ’09 and I’m starting to work on that now.

Steven Martin - Slater Capital

Troy is there any update on, and I bet some of this is in the Q, the Minneapolis litigation and on the Texas patron tax?

Troy H. Lowrie

There is. It’s in the Q. I’ll let Courtney tell you.

Courtney Cowgill

The current update on Minneapolis is on page 13 of the Q and right now we are in discovery on that but it’s just such an odd lawsuit we don’t really anticipate it going a whole lot further.

The Texas patron tax, that’s another issue. Right now it’s been declared unconstitutional and we’re just waiting for that lawsuit to go to the Texas Supreme Court. Of course we are cheerfully paying our deposit into the State of Texas. We have to file a protest letter and we had to file lawsuits to get that money back. So we are following the letter of the law to not jeopardize any single penny of that payment but I will tell you it might become a line item on our cash flow.

Steven Martin - Slater Capital

You’re paying it and you’re expensing it I presume?

Courtney Cowgill

Actually we’re showing it as a deposit right now with the State of Texas. It’s almost a receivable. We’re not showing it as current but it’s really not being expensed and the reason is according to the law as it sits today that money is being paid totally under protest.

Steven Martin - Slater Capital

So that is somewhere in the balance sheet in deposits and prepaids?

Courtney Cowgill

Yes. I don’t have the number exactly in front of me of that detail but remember we only have two clubs in Texas. We have one in Dallas and one in Fort Worth so it’s not a huge cash drain like it would be for our competitor who has I think seven clubs.

Troy H. Lowrie

And both of our clubs are more of a C model.

Courtney Cowgill

So it hurts but it’s not painful.

Operator

Our next question comes from [David Fore - Montgomery Street].

[David Fore - Montgomery Street]

Looks like this is staying steady in spite of the slowing economy for sure at this point, but more on the acquisition side. It seems to me from what you said earlier that private club valuations are not tracking at all with public valuations between you guys and your competitor. What’s going to pull that rationale down [inaudible] owners you think going forward?

Troy H. Lowrie

I think the sellers out there that might have got interest in selling last year; I think the economy’s made people a little nervous. I think they thought, “Hey, there are companies out here paying big dollars for clubs.” Now our stocks are down. Both public companies are going to be a little more picky, a little more choosy.

I think that’s going to bring prices down. Although a seller out there might not have decreases in his revenue yet, he might be looking to see if that happens and be a more motivated seller. I think what’s going to happen is the sellers are going to have to get back down to earth where we might have said, “Hey, we can go four times last year.” We’re not going to do that this year. They’ll come back to earth and their multiples will come more in line with the trading multiples that we have.

[David Fore - Montgomery Street]

Maybe more for Courtney. Can you just go into your revolver and discuss sales quota? What kind of rates have you thrown out by the VCs or the [inaudible] guys or the banks and maybe what the sense of what these guys are searching for in this current market?

Courtney Cowgill

They’re looking for a lot of warrants. Right now I’m finding prime + 1 and prime + 2 so it’s not the rates that really bug me. It’s the fact that people want so many warrants to do it.

Troy H. Lowrie

30% to 50% coverage.

Courtney Cowgill

Yes. And forget it.

Operator

Our next question comes from [Scott Newsbon - Brautlin Capital].

[Scott Newsbon - Brautlin Capital]

Could you guys talk a little bit more about 2009? What I’d like to try to get a sense of is the potential earnings accretion from deploying your free cash flow separate from what your run rate earnings would look like assuming flat same-store sales and assuming let’s just say same-store sales up 3% to 5% and try to get a sense of how much operating leverage is in the business outside of the ability to do accretive deployment of cash flow?

Troy H. Lowrie

Basically, and I think we’ve talked about this on the second conference call and the first conference call quarters, we could be accretive by a penny for every $1 million of free cash that we produce. Based on free cash flows the run rate going into next year could be $0.06 to $0.08 that we could be accretive through acquisition. We could also be accretive by $0.04 or $0.05 just through the pay-down of this 14% debt. We’re finding out that we could be pretty accretive at stock buy-backs at this level also. We think that worst case scenario is $0.04 of accretion; best case scenario $0.08 accretion with no same-store sales increases.

[Scott Newsbon - Brautlin Capital]

What about if you were to get same-store sales up a couple of percent? How does that flow through with the various one-time expenses this year and some of the cost reductions?

Troy H. Lowrie

Then you’d be closer to $0.10 at that point.

[Scott Newsbon - Brautlin Capital]

With same-store sales up what to get to about $0.10? 2% or 3% or do I need 4% or 5% to get that to happen?

Troy H. Lowrie

2% or 3%.

[Scott Newsbon - Brautlin Capital]

So if I’m reading it right, we’re going to finish this year with a run rate earnings of about $0.42, $0.43, or $0.44 a share?

Troy H. Lowrie

I’d call the run rate right now $0.40.

[Scott Newsbon - Brautlin Capital]

So Q3 is the run rate?

Troy H. Lowrie

Correct.

[Scott Newsbon - Brautlin Capital]

What am I missing then in Q3 over Q4 if Q3 you had some of these higher level of expenses and you had the acquisition that you had to pay for?

Courtney Cowgill

If you recall when I talked in Q2, I talked about cleaning up the balance sheet. We have scrubbed out the balance sheet now but we are in the process of researching a lot of items to make sure whether they need to be written off or retained and what the value of them is. That’s my homework assignment plus the finishing of the SOX compliance for Q4.

[Scott Newsbon - Brautlin Capital]

So $0.40 run rate with up to $0.10 accretion at 2% to 3% same-store sales including the free cash flow being used plus there’s the opportunity to do some balance sheet restructuring here?

Courtney Cowgill

Yes.

[Scott Newsbon - Brautlin Capital]

On the balance sheet side, have you explored sale and leasebacks of various properties to extract cheaper debt and pay down higher cost debt?

Troy H. Lowrie

We’re exploring that currently.

Courtney Cowgill

That does appeal to us a lot.

[Scott Newsbon - Brautlin Capital]

What will be the deciding factor whether you do that?

Courtney Cowgill

The rate of return. Each deal needs to be evaluated separately. So I can’t sit here and tell you what’s going to be the factor which makes it appealing or not appealing.

[Scott Newsbon - Brautlin Capital]

Have you been presented with interesting options for doing that so far? Were you able to get mortgages if you wanted them?

Troy H. Lowrie

We’re pretty close. I think now that the credit’s loosening a little bit we’re pretty close to getting that done.

Operator

That does conclude today’s question and answer session. I would like to turn the call back over to management for any additional or closing remarks.

Troy H. Lowrie

We just want to thank everybody for joining us today. We think it was a great quarter. Please look at the free cash flow. Look deeper than the balance sheet. Look a little deeper and you’ll find that the free cash flow’s really showing through for us in a time where cash is king. We appreciate your time today and look forward to talking to you at the fourth quarter.

Operator

That does conclude today’s conference. We appreciate your participation. You may now disconnect.

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