3 Sin Stocks To Spice Up Your Portfolio

Includes: CAB, FHCO, RICK
by: Finance For Yuppies

Companies engaged in the businesses of gambling, alcohol, tobacco, guns, contraceptives, and adult entertainment are not generally high on the list of morally upstanding citizens' investment decisions. I for one will leave moralizing to better men. Several names in each of these industries offer the potential for disproportionate returns because they are too small to warrant major institutional coverage or the stigma associated with their industry scares away larger players. The article below highlights three players that are uniquely positioned in their respective industries to potentially produce above market returns.

Rick's Cabaret International Inc. (NASDAQ:RICK)

Industry: "Gentleman's Clubs"

Catalyst Summary

· Only roughly 40 of the 500 clubs that Rick's management believes are potential acquisition targets have been purchased

· Lower debt costs as the firm obtains more traditional funding

· The implementation of a REIT in conjunction with other industry operators

· Continued growth in the non-adult Bombshells and Ricky Bobby's Sports Bar

· Gains from the openings of Vivid Cabaret in LA and New York

Rick's Cabaret is the only publicly traded "cabaret" (strip club) operator in the world. The company owns and operates 37 clubs with 6 additional locations slated for completion by year's end. The company is a serial acquirer that is able to purchase clubs for an average of approximately 3x EBITDA, according to the company's last conference call. Think of Rick's Cabaret as an adult entertainment private equity firm that is buying out small inefficient operators and rolling them up. Rick's Cabaret brings purchasing efficiencies in critical areas such as alcohol and superior management.

In addition, Rick's Cabaret recently received its first bank loan since 2008 at Prime plus 1.5% or approximately 6.25%. Historically the company had to rely on expensive seller financed promissory notes with rates, according to the firm's 2012 10K, as high as 14% (Tootsie's acquisition). If Rick's Cabaret can successfully replace its existing financing with lower cost bank debt, it will be highly accretive to the firm's bottom line.

Unlike other restaurant operators, the company owns the majority of its real estate. Leasing is difficult in the cabaret business because the license to sell alcohol is usually specific to the owner of the real estate. Management is currently in discussions with several other industry operators to create a REIT. Rick's would spin off its existing real estate assets into the REIT. I plan on going into the potential economics of the REIT spin-off in a future article.

Over the course of the last two years, Rick's has been diversifying its operations into non-adult themed restaurants, namely Bombshells and Ricky Bobby's Sports Bar. Both are Hooters-like male-oriented sports bars. According to management's Q3 earnings call, Ricky Bobby's is vastly exceeding management's expectations with over $80,000 in revenue during its first week of operations. Bombshells is also averaging over $65,000 a week in revenue. Both establishments will generate higher earnings than other industry comparables due to their extremely favorable 50% high margin alcohol mix. The firm's new large format Vivid branded clubs also offer significant growth potential. The Vivid brand name has strong recognition. In New York, management has reduced the Vivid property's acquisition cost through the clever sale of air rights.


· Texas "pole" tax

· Stricter regulations in Texas or New York

The company has been fighting a legal battle with the state of Texas for several years over the imposition of a Sexually Oriented Business or "poll" tax on cabaret establishments. The case has gone back and forth on appeals until it was ultimately not considered by the Texas Supreme Court and remanded to District Court, where it is still pending. The company has been accruing the liability for the tax, but has not paid any cash to Texas since 2008. In the event that the company had to pay the tax it would have a significant impact on Rick's Cabaret's cash flows.

The majority of the firm's clubs are located in Texas. A material change in the regulatory structure in Texas that made the operation of gentleman's clubs more difficult or the imposition of stricter zoning regulations on a local level could depress earnings. Similarly, the club operates one of its largest clubs in New York City and is opening another. New York recently ruled that gentleman's club entertainers are not independent contractors and are therefore subject to minimum wage requirements and have a broader set of rights. This ruling could increase the firm's costs going forward.

The Female Health Company (NASDAQ:FHCO)

Industry: Female contraceptives

Catalyst Summary

· Strong balance sheet with the potential for accelerated repurchase

· Potential acquisition target

· New customer acquisition

The Female Health Company makes FC2, the only FDA approved female condom. The firm primarily sells to large government backed or charity organizations that distribute the condoms. The company's only major competitor is the Cupid condom, made by a significantly smaller Indian producer.

After collecting roughly $6m in cash from the drawdown of accounts receivables, the firm has upped its cash position to $11.8m as of September 30, 2013. In addition, the firm has an undrawn $2m credit line. Management indicated in its Q3 2013 conference call that it has only purchased 53,000 of the 1 million shares it is authorized to repurchase. Given the firm's small float and roughly 100k shares a day in daily volume, a material increase in buybacks could provide significant support for the stock.

The global market for male condoms is dominated by Church and Dwight (primarily in the US) and Reckitt Benckiser Plc. Both firms have the liquidity and size to easily acquire the Female Health Company. Either company could benefit from integrating FHCO into its operations and pushing the company's product to retail distributors alongside its existing condoms.

The company's customer base consists of three large organizations that collectively constitute 85% of FHCO's revenues. There are currently several initiatives from major international organizations that could help the company diversify its revenue base. The company has recently received increased interest from the Los Angeles Health Department, which has started distributing FHCO's condoms as part of a larger condom distribution plan. Furthermore, the British government in conjunction with the Bill and Melinda Gates foundation has recently committed to providing contraceptives to 69 developing countries. The FC2 will likely constitute part of the program's roughly $4.2m budget.


· The loss of one or more major customers

· Competition from existing condom manufacturers

As previously mentioned, the firm derives 85% of its revenues from 3 customers (Sekunjalo Investments Corp., John Snow Inc, and UNFPA). In the event that any one of these customers were to significantly decrease its purchases, FHCO would witness a significant decline in revenues that are unlikely to be offset in the short term. This risk is partially mitigated by long-term contracts and the firm's patent on the FC2, which has not been replicated by competitors.

Despite the firm's patent and dominant position in the female condom market there is a possibility that the existing major condom manufacturers will enter the market or that Cupid will more aggressively market its condom. The small size of the female condom market and the absence of a retail market at present make the female condom market relatively unattractive for large players to enter on their own. The FC2 has a key advantage over the Cupid condom that allows FHCO to sustain a price premium. FHCO condoms are made of Nitrile Polymer, which eliminates the issues associated with users that are allergic to latex.

Cabela's Incorporated (NYSE:CAB)

Industry: Fire arms

Catalyst Summary

· Small store count leaves significant room for growth, especially in the Southeast

· New higher turnover store format

· Credit Card operations to expand as stores enter more urbanized markets

Cabela's is one of the largest gun retailers in the US and derives about 12% of its revenues from the sale of firearms. Cabela's operates 40 retail locations in the US and Canada that sell a variety of goods including hunting and camping gear, fire arms, and other outdoor merchandise. The majority of the company's stores are concentrated in rural areas.

At present the company has a tiny footprint compared with its much larger competitors, Bass Pro Shop with over 70 stores and Dick's Sporting Goods with over 500 stores. Cabela's management is planning on opening 13-14 stores per year, primarily in the southeastern United States where it has virtually no penetration. In addition, Cabela's management is changing the store format. New stores will only be 80,000 sq ft. These new stores should have higher inventory turns and generally require significantly smaller capex of $10-14m per store.

Cabela's currently has over 1.5m Cabela's Club Visa Cards. According to management's presentation to Imperial Capital in September, approximately 27% of the firm's sales are on the Cabela's Visa. The average Cabela's customer has an average FICO of 793, which is significantly higher than all major card issuers. Approximately 73% of existing card holders sign up at Cabela's retail locations. As Cabela's moves into more suburban areas with higher populations, the company will have a greater population per store through which to drive a greater number of credit card signups. Issuing additional cards will be highly accretive to the firm's bottom line as the credit card business has an average operating margin of 23% versus a firm wide operating margin of approximately 10.2% as of Q3 2013.


· Increased competition in new markets

· Slowing firearm sales or new regulations

Cabela's is entering a southeastern market that already has major competitors including Bass Pro shops and Dick's Field and Stream. By moving into new areas that have a more suburban customer base, Cabela's may have to significantly change its marketing strategy and will potentially face greater pricing pressure. Furthermore, the smaller format store may detract from the traditional perception of the store as a destination in itself, whereas before, shoppers would drive for several hours to visit a Cabela's store.

The company's fire arms sales increased dramatically in 2012 as a result of fears over increased gun regulations following several shootings. In the last quarter, arm same store comparables fell 2.5% while the company overall witnessed same store sales growth of 3.9%. If the company were to witness a continued fall in firearm sales or new regulations that make obtaining a firearm significantly more difficult are enacted, Cabela's earnings would be materially affected.

Disclosure: I am long RICK, CAB, FHCO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I own shares in RICK and CAB. I have owned FHCO in the past and will likely purchase shares in the future.