The prudent investor objectively considers the risk and reward characteristics of a stock before making an investment decision. If you take care to avoid the downside, the upside usually takes care of itself - in other words, look down first before looking up.
After reading too many articles on Rick's Cabaret (RICK) that are groundlessly bullish, I am compelled to inform the public with a bearish article pointing to some of the misconceptions of the bulls.
Bulls' Fantasy #1: Investors Avoid Sin Stocks
First, RICK has a microscopic market cap of around $100 million, but the stock gets a lot of attention - far more than other companies of comparable sizes - for an obvious reasons: the stock is the only publicly listed strip club management company. The stock is often labeled a sin stock and the knee-jerk conclusion is that this must be an overlooked opportunity. From my experience researching and discussing RICK with other investors, it is far more likely that the opposite is true: there are far more investors with the primal urge to look at the stock then those who shun it for moral reasons.
Bulls' Fantasy #2: High Barrier to Entry for the Strip Club Business
The second misconception is that strip clubs have a high barrier to entry because it is very difficult for strip clubs to get business licenses, which means that legacy strip clubs with existing licenses are highly valuable.
For those of you who believe in this fantasy, just open up the 2012 10-K and find the following disclosure:
The adult entertainment business is highly competitive with respect to price, service and location. All of our nightclubs compete with a number of locally owned adult clubs, some of whose names may have name recognition that equals that of ours. While there may be restrictions on the location of a so-called "sexually oriented business", there are low barriers to entry into the adult cabaret entertainment market…
The granting of a Sexually Oriented Business Permit is not subject to discretion; the Business Permit must be granted if the proposed operation satisfies the requirements of the Ordinance.
Estimates vary, but there are approximately 4,000 strip clubs in the U.S., less than 40 of which belong to RICK. The truth is that the adult entertainment market is extremely fragmented because it is one of the easiest businesses to get into. If Joe Schmo saved up $100,000 and wants to quit his job and start a business, what are some of the first ideas that pop up in his mind? Opening a strip club is probably not too far down the list of considerations compared to, say, opening a car manufacturing company. Remember, the CEO of RICK got into the strip club business by selling his baseball card collection for ~$40,000 and using half of that amount to buy his first strip club when he was barely out of this teens.
The bottom line is that RICK's moat is about a foot wide.
Bulls' Fantasy #3: Growth Via Acquisitions and Industry Consolidation is a Great Idea
Since RICK is growing by acquisitions and trying to consolidate this very fragmented market, many investors view this as a plus. The fact is that the benefits of consolidation in the strip club market are unproven. Let's look at an excerpt from a 2006 Wall Street Journal article I pulled straight from RICK's website:
Two primary issues weigh on the companies: First, adult-entertainment companies in general have struggled to consolidate their niches in the industry and produce consistent profits. "It's amazing how high-profile the category is, but at the same time, these companies have not made fabulous amounts of money," said Matt Harrigan, an analyst with boutique investment firm Janco Partners in Denver.
Subsequent developments have only confirmed the above analyst's observations. Recall that due to the costs associated with closing an unprofitable club in Las Vegas, FY2010 ended with a net loss of $0.82 per share, a number greater than the subsequent gains in 2011 and 2012.
The bottom line is that we don't yet know if growth via acquisitions is such a great idea in this industry.
Bulls' Fantasy #4: Growth is Sustainable
Growing organically and buying your growth are entirely different. The truth is that RICK's high recent growths figures are mainly driven by acquisitions and a rebound from the economic downturn. Let's take a look at RICK's organic growth as disclosed in its 10-K:
- FY12 vs. FY11: "Our income from operations for our nightclub operations for the same-location-same-period decreased by 1.4%."
- FY11 vs. FY10: "Our income from operations for our nightclub operations for the same-location-same-period increased by 18.3%."
- FY10 vs. FY09: "Our income from operations for our nightclub operations for the same-location-same-period increased by 4.5%."
- FY09 vs. FY08: "Our income from operations for our nightclub operations for the same-location-same-period decreased by 18.2%."
The fact that FY12 organic growth is non-existent and the current 9-month ending 6/2013 is also flat should be evidence that the company is not fundamentally becoming more profitable over time.
In 2008, RICK has ~$33 million in long-term debt. As of today, the company has ~$79 million in long-term debt, which includes a $2.5 million convertible debenture the company announced on 9/4/2013.
Since the recent debt binge is not sustainable, the recent top-line growth is also not sustainable. I believe that RICK is already pushing the limits of leverage. The company's net current assets are currently at a negative $9 million, implying that the company would not be able to pay current liabilities with current assets and will need to draw on operating cash flow and thus crowd out other uses of cash.
The company's debt is also extremely expensive and dilutive and will likely get more so as its increased leverage will make incremental debt more risky. In a recent 8-K, the company announced that on 8/28/2013, it issued a 10% Convertible Debenture with a principal amount of $2,500,000 and a warrant to purchase a total of 48,780 shares of RICK common stock. "The Debenture has a term of three years, is convertible into shares of our common stock at a conversion price of $10.25 per share and has an annual interest rate of 10%. The Warrant has an exercise price of $10.25 per share and expires on August 28, 2016." For all of this, the company will only receive $2,350,000 net of a $150,000 advisor fee related to sale of the Debenture and Warrant.
In my view, the company must be either extremely optimistic or in an extreme need of cash. I can't see RICK's future, but I know that the story of aggressive expansion on the back of debt often ends up in tears.
I still hear people crying out how cheap RICK is at current levels ($11.81 as of 9/13's close). However, given the lack of organic growth, RICK's increasingly risky capital structure, and the lack of an economic moat, I believe RICK's current levels are fair. I'm watching this stock, but I won't be pulling the trigger until it falls back to below $9 per share or until the fundamentals have changed for the better.