RCI Hospitality: A Long Awaited Deal

| About: RCI Hospitality (RICK)

Summary

RCI made a splash with a $26M acquisition of a premier South Florida club.

The company also posted decent Q2 results.

I love the deal, and Langan's new capital allocation philosophy.

I am upgrading my fair value to $19-21.

While RCI Hospitality (NASDAQ:RICK) posted decent Q2 earnings after the bell yesterday, the big news of the day was the M&A that I've been waiting for as the stock rose. In addition to the acquisition of a small club in St. Louis in late April, RCI announced the acquisition of South Florida's Scarlett's Cabaret. As I predicted in my previous note (or really, RCI foreshadowed) RCI has returned to M&A given the current price of its stock as well as CEO Eric Langan's views on capital allocation.

As opposed to focusing on the quarter, which was decent, I will briefly touch on the quarterly highlights, and then focus on Scarlett's. In short, the quarter was fine, but what I'm really excited about is the Scarlett's acquisition.

Q2'17: Solid but not remarkable

Overall, Q2 results were decent. Comparable store revenue grew 2.7% y/y, though total revenue was up just 0.4% after the company divested Robust Energy Drinks and closed or sold low profitability units. Operating income was basically flat at $7.5 million, and non-GAAP EPS increased nearly 6% due to a lower share count.

No item stuck out as a red flag or particularly strong highlight, though it was nice to see 8.4% y/y jump in operating income in the nightclub segment that was driven by a jump in service revenue. Bombshells performance was solid, with same-store sales up 3.2% as the concept continues to mature.

Scarlett's Cabaret: The Perfect Acquisition Target

Scarlett's Cabaret is the ideal acquisition target for RCI Hospitality. Due to its relatively large size ($13M in sales and $6M in EBITDA), the market for acquirers for an asset like this in the strip club space is very limited. With the industry dominated by private owners, I doubt there are many existing club owners that could pay a reasonable valuation.

In addition to its size, Scarlett's is really a premier asset in the space. With strong reviews and a got reputation in the industry, Scarlett's is situated between Miami and Fort Lauderdale, providing patrons from either city easy access. As we all know, this area of South Florida is a popular site for partying tourists and bachelor parties, making it awfully conducive to high amounts of alcohol and service revenues.

You may rightly ask, what is the moat of this particular club? I think over the years, the club has built up a strong reputation, but more importantly, RCI is already a strong operator in the region, owning the dominant Tootsie's Cabaret, which is only about 5 miles away. Therefore, I think RCI has a strong grasp of the markets competitive dynamics, which will help keep the club performing well.

Most importantly, the valuation was terrific. At $25.95 million, RCI paid roughly 4.3-4.5x EBITDA and just 2x sales for the club. RCI may squeeze out some modest back office synergies of a few thousand dollars, but I am not particularly worried given the low price RCI paid.

Importantly, RCI structured the transaction as an asset deal, which is brilliant for two reasons. For one, an asset deal structure likely provides RCI protection against legacy liabilities. Secondly, the purchase price amortization will be tax deductible. This translates into a reduction in cash taxes for the next 15 years. Had RCI opted for a stock transaction, the amortization would be deductible from GAAP tax expense but not cash tax expense. Although this may not seem very material, this tax asset creates a lot of value for shareholders.

I like the direction RCI is heading

After another decent quarter and a savvy acquisition, I am increasing my fair value range to $19-21 from $17-19. I purchased shares in March when the stock dipped into the mid-$16 range, and I may add to my position at current levels due to my increased confidence in the company.

Disclosure: I am/we are long RICK.

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.

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