- Rick's has a low P/E multiple compared to similar companies.
- Rick's is in a very high margin business that is fragmented allowing for acquisitions to fuel growth.
- The creation of a Rick's REIT could further unlock value for the company.
Rick's Cabaret International (NASDAQ:RICK) is a small capitalization gentlemen's club company that is undervalued. The company has a large growth potential as it expands the number restaurant and cabaret locations from the 43 it currently has. The stock is has a P/E earnings ratio of about 10 and operates in a very high margin industry. The gentlemen's club industry is highly fragmented. This reminds me of the jewelry industry. Signet (NYSE:SIG) is the main player in a fragmented space. I previously made huge profits in this stock and sold on the news that it would acquire Zale. I look to do the same with Rick's Cabaret. Rick's is looking into forming a real estate investment trust which will provide the company with cash to further grow the number of locations that it has. The company is certainly not perfectly run as it has had legal issues with its "Ricky Bobby" restaurant theme. The company is now scrapping plans to expand upon this theme. The legal issues will be over in the third quarter, which is a positive. Overall, I believe the stock is a long term buy opportunity at its current level.
The company is has described itself in a turnaround situation on its second quarter conference call. The same store sales of Club Onyx, which caters to African-American professionals, certainly have been a struggle. Other than this segment of the business, which consists of 4 of the 43 total locations, I would describe the past two solid quarters that the company has had as re-acceleration of the business instead of a turnaround.
This reasoning can be visually shown in this chart. The company was stuck in the $27-$29 million dollar revenue range for 5 quarters and it broke out of this range in the second quarter of this year. The entire earnings report for the third quarter has not been released yet, but the company announced that it had revenues of $33.1 million for the quarter.
The numbers that have been released show the third quarter to be a thing of beauty. Same store sales were up 5.1% year over year and without Onyx they were up 6.9%. Same store sales revenue was $28.9 compared to $27 million in the second quarter. There were 37 stores open in the 3rd quarter of 2013 and now there are 43 stores open. This led to revenues increasing 18.3% year over year. The new Vivid Cabaret in NY and the new Bombshells restaurant in Texas both did particularly well. The Vivid Cabaret has actually helped lead to increases in sales at the Rick's in Manhattan as patrons decided to bar hop. Rick's Cabaret in Manhattan had 6% year over year growth in sales. This is an impressive effect because in most industries a similar type of store in close proximity to another one would lead to a cannibalization of sales.
In the third quarter the company resolved many legal issues which should increase the company's earnings visibility going forward. It settled the "Ricky Bobby" lawsuit by changing the name of its restaurant to "Pole Position Sports Saloon and Restaurant". The "Ricky Bobby" themed restaurants were originally supposed to be opened up throughout the country, but because of this lawsuit this restaurant will be the only one with this name. It seems like this was a very obvious lawsuit waiting to happen as the company clearly copied the name from the "Talladega Nights" movie. The company states that the Bombshells restaurant theme was doing better anyway, so the loss of this themed restaurant is not a big deal. This may be an example of sugar coating information because the company previously touted the "Ricky Bobby" theme as a way to expand the company's earnings.
The company's Bombshell theme is still a positive for the company even though their other restaurant theme fizzled. Bombshell restaurants will be opened up near military bases catering to men in the military. Currently the company has 3 locations and plans to open 2 more in the second half of this year. The Bombshell restaurants have 15%-25% operating margins and the second quarter revenues were similar to their adult clubs on a per store basis.
Another legal issue that the company resolved in the third quarter was a major dram shop case. This type case involves the liability of commercial establishments that sell alcohol. Rick's plans to file for reimbursement from the court overseeing the dissolution of Rick's former insurance company. Finally, Rick's resolved all claims with the state of Nevada over taxes related to Rick's former Los Vegas adult club. In total there will be $3.2 million in one-time legal charges in the third quarter.
To put into context the operating margin estimates that I gave you for the Bombshells restaurant, the total operating margins for the second quarter were 22.7% compared to 21.7% in Q2 2013. The gross margins are high for most categories of the company's business.
As you can see in this chart the Service section of the business which makes of 44% of 2013 revenues has almost 100% gross margin. The Alcohol section of the business which makes 40.6% of 2013 revenues has a 78.5% gross margin.
A catalyst that could increase the company's earnings per share and allow it to buy back more stock or possibly pay a dividend is the repayment of the high costing debt related to the Tootsie's club. The company has already put into place a $10 million buyback, which is significant considering that the market cap of the company is only $110 million. The debt costs the company 14% so it is imperative that the company pays it off as soon as possible. As of the second quarter the company has paid down $1.6 million of the debt shrinking its total to $3.7 million. The company expects to pay off this debt by the second quarter of next year. Because this debt is so expensive, paying it off will help the company. According to the 10K, the total company debt is $78.6 million. To put the 14% in context, the two largest debts which are due in 2024 have a 9.5% interest rate. These two notes payable make up $30.2 million of the total debt of the firm.
Thirty six of the forty three clubs and restaurants that the company operates are in the state of Texas. Because it can be difficult to get a new strip club built in a new area, many of the strip clubs in America are clustered in certain neighborhoods. As I showed with the Vivid and Rick's in NYC this leads to increases in same store sales among the clubs. The Texas economy has been one of the best states in the country, which is great for Rick's. The unemployment rate of Texas is 5.1% compared to 6.1% in the entire country, as of June 2014. The GDP growth for the state of Texas was 3.7% in 2013 compared to 1.8% growth in America in the same time period. The state of Texas has great economy because it is one of seven states in America with no income tax and it is experiencing an oil and gas boom because of natural gas fracking. Odessa, Texas is a city that has experienced a huge boom in its economy because of natural gas fracking. The city has experienced the second largest rise in personal income in the country. Personal income has grown 6.98% in the past 3 years. Rick's has a Jaguars Club in Odessa and will be opening a Rick's Cabaret in Odessa in the third quarter.
The jewelry industry is highly fragmented with many stores being 'mom and pop' owned. When Signet bought Zale in February of this year the combined company had only a 16% market share which was by far the largest in America. The adult gentlemen's club industry is highly also highly fragmented with Rick's being the largest player. Most of the clubs in this industry are owned by 'mom and pop' as well. The company has guidance for $130 million in revenue which is a small fraction of the industry which has $2 billion in revenue. The industry has 3,800- 4,000 clubs in America. Because Rick's is a huge player, it is the main exit strategy for sellers. This acquisition strategy is similar to what Signet was doing before it acquired Zale. The most recent important acquisition that Rick's has made is Club O which was $11 million. The entire building which is 56,000 square feet will be converted into a Tootsie's. This will be the company's first foray into Illinois. It will be in Harvey which is a suburb of Chicago. This will be the second Tootsie's branded location.
Another important catalyst is the formation of a REIT. This would occur by selling the real estate that it owns to the market. The company stated that the REIT would yield 8%. On the company's second quarter conference call management said that they would provide important updates on asset sales on the next earnings call. The CEO Eric Langan stated that it has $90-$100 million in real estate and $40-$45 million in debt against the real estate. This would give the company $40-$50 million in cash. This would lower the company's debt load and allow it to be structured for expansion like traditional publicly traded leisure industry firms.
The company provided guidance for it to earn $1.10 per share on a GAAP basis and have 20%-30% annual growth in revenues. With the stock currently trading at $11.13 this would give it a 10.1 P/E multiple, which is incredibly low. Considering the fact that it should continue to grow its earnings with the continued opening of new clubs and Bombshell restaurants this multiple is way too low. The company showed on its January investor presentation that the average leisure industry stock traded at 22.9 P/E ratio. It's difficult to find companies that directly compare to Rick's because most of the other players in the industry are 'mom and pops'. If you look at the PEGs of bigger growth restaurants you can recognize how cheap RICK is.
Buffalo Wild Wings (NASDAQ:BWLD)
Panera Bread (NASDAQ:PNRA)
Therefore, if Rick's executes on its growth projections I would expect the stock to trade at a similar PEG. The company provided a 5 year sales growth rate of 11.6%. This estimate is very conservative because in its past 5 years the company has 13.7% growth in sales. If it traded at the PEG of Panera Bread, which is the lowest of the three companies, the stock price would be $17.09, which is a 53% increase from its current level.
According to this stock screen that I ran on the Financial Visualizations website, RICK had the lowest PEG, P/E, and P/B among the stocks that met the criteria. As you can see in the screen shot, my filters were market cap, industry, country, stock price, operating margin, sector, and 5 year EPS growth.
In conclusion, I believe that Rick's stock is a buy. I will be further looking into Einstein Noah Restaurant Group (NASDAQ:BAGL) as it caught my eye as I was researching Rick's.
There are many risks to this thesis. One risk would be that the company cannot get the REIT into place. The company stated that this transaction is not complete. We shall see in the next earnings report how well this is going. Another risk to this thesis is the economy. I believe that the company is a long term buy, but if the economy goes into a recession then earnings will suffer as they did in the last recession. The company is highly levered to the economy because of the discretionary nature of the product. The company will experience its one time legal charges in the third quarter, so this will hurt its profitability. This negative headline may hurt the stock. Another risk for the long term is that existing gentlemen's club owners will be willing to sell their businesses for reasonable prices as Club O was. Finally, the expansion of the Bombshells brand has the risk that it is not as successful in new markets as it has been in the markets that it is currently in.
Disclosure: The author has no positions in any stocks mentioned, but may initiate a long position in RICK over the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.