RCI Hospitality Holdings: An Undervalued Company With An Unconventional Business

Summary

• RICK has strong FCF generation with a focus on future growth.
• The company has enough liquidity to survive through the pandemic.
• It offers compelling long-term returns for shareholders.

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RCI Hospitality Holdings, Inc. (NYSE:NASDAQ:RICK) is a company that owns restaurants, called Bombshells, and gentlemen clubs under various names, targeting different demographics.

RICK's share price has plummeted due to the lockdown caused by the coronavirus, which forced them to temporarily close their locations. The share price decreased 70% and has recovered slightly since. Currently, as of 18th of May, the share price is around $10. I believe that the current share price does not reflect the long-term potential of the company and the market is strongly punishing RICK due to the lockdown. I am convinced that the company can pull through the pandemic with the cash on hand and additional borrowings, if necessary, making it an attractive company to hold in your portfolio with a long-term perspective. I am going to dive deeper in their financials and business model to explain why I believe RICK has a bright future ahead.

Business:

As of 30th of September 2019 (fiscal year close), they operated eight bombshells, all in Texas, and have since then increased the number by two. The restaurants are characterized by a military theme where the waitresses wear uniforms and all the food and drinks have military names. Bombshells are also open for franchising in all 50 states. RICK generates revenue in Bombshells from the sale of alcoholic beverages (58%) and food and merchandise (42%).

As of 30th of September 2019, they operated 38 nightclubs serving mainly businessmen and professionals. The revenue is distributed as follows: 45.7% through service revenues, 38.5% alcoholic beverages, 8.8% food and merchandise and 7% through other sources such as cover and parking fees.

They have a third segment, their media group, which is not relevant to their revenue stream but it is of strategic importance to their acquisition strategy. They serve the adult nightclub industry with conventions, trade shows, websites, and other publications…

The main source of revenue is proportional to the number of units; nightclubs generate 82% and Bombshells provide 17% of the total revenue.

Source: Annual reports 2019

RICK breaks down their revenues and costs by market segment, which allows us to analyze the unit-based performance of both Nightclub and Bombshell segments. In 2019, the average operating profit margin for a nightclub was approximately 40%, USD1.57M, and 15%, USD462.5K, for a Bombshell (I considered Revenues - COGS - Salaries - Selling and Administrative expenses). However, these calculations are based on the data from the annual reports and do not include new units.

Management breaks down the changes in YoY revenue. The primary source of increased revenue for Bombshells are new openings, while acquisitions have driven revenue increase for Nightclubs. Management breaks down the change in segment revenue by same-store sales, new units and closed units.

Bombshells:

Nightclubs:

Source: Annual reports 2019

Regarding past performance, RICK has consistent revenue growth and has been able to maintain operating margin between 20-25%, which has led to higher FCF over time.

Source: Own, based on data published by RICK. Data is in thousands of dollars, except earnings per share.

Capital allocation strategy:

RICK has strict guidelines which are focused on buying/opening new units, disposing underperforming units and buying back shares.

Source: Company Q1 presentation

RICK also plans to pay down their most expensive debt if it makes sense on a tax-adjusted basis. These guidelines ensure that they are using their free cash flow in a responsible manner, aimed to increase returns to shareholders.

The ability of RICK to expand is impressive. Let's take one of the latest acquisitions of a gentlemen club for 15M. Out of those 15M, 7.2M were used to buy the club, while 7.8M were used to acquire the real estate. This translates to an average return on investment before depreciation, interests and taxes (operating margin calculated above/investment) of 21%. This is considering that the club would perform averagely. Specifically, this club was generating 2.4M in EBITDA with the previous owners, which translates into a x3 EBITDA multiple.

Furthermore, RICK has the opportunity to use the real estate as leverage, as they are doing currently, and in case they were to sell the club in the future, they would also receive the increase in value of the real estate.

A breakdown of the capital allocation strategy is below, in which they show how they have increased their free cash flow to buy back shares and increase the number of units.

Source: Company Q1 results 2020 presentation.

Solid liquidity position:

The generation of cash flows is solid. However, the lockdown has forced them to reduce their client capacity and to close temporarily some nightclubs and Bombshells. On March 17th, the management addressed the shareholders stating that they do not have liquidity issues, since they had strong sales:

We want our investors to know we are confident we have the financial resources to weather this storm. Sales were strong in the second fiscal quarter through the second week of March. We have enough cash and resources, including excess borrowing capacity based on the composition of our asset base.

We have been and are continuing to plan and prepare for this uncertain time. We have developed contingency plans and have already reduced many costs, and we will be lowering expenses further. In addition, our pending Northeast Corridor club acquisition will not close in the March quarter as anticipated.

In a press release from April 9th updating on the situation, they stated the following:

However, due to strong sales during the first 10 weeks of 2Q20 and our subsidiaries' ability to begin reducing costs, we believe we ended March with sufficient working capital on hand to fund operations into July without additional borrowings.

In this line of business, short-term debt is not an issue since they receive cash instantly after a service has been provided while the accounts payable carry a longer payment term. However, long-term debt could be a potential issue if no cash flow is generated. Their obligations are broken down below.

Source: Company financial statements.

At the end of 2019, RICK ended with 13M of cash and cash equivalents and generated 9M of free cash flow (they calculate it as cash from operating activities - maintenance capital expenditures) for Q1 (3 months ended Dec 31st).With the cash in hand ($9.8M as of Q12020) plus any additional borrowings that they may incur, the financial position of the company is not at risk. Moreover, Rick announced on April 29th that they are opening all Bombshells in the following weeks and if the pandemic situation improves, they could open the rest of their locations by May 18th.

Valuation:

I am going to valuate Rick on a price to free cash flow basis. Obviously, the free cash flow estimate for 2020 of 30M is not going to be met due to the impact of coronavirus. However, since we already established that the company should not have any issues on making it through the pandemic, I think it would be reasonable to consider that 30M could be met during 2021. At the end of 2019, there were an average of 9.32M shares outstanding, which gives us a forward 2021 FCF of $3.22/share. Management has stated in their capital allocation strategy that they would start buying shares at a yield of 10%. This implies that a multiple of 10 would be a low-end multiple for the share to be trading at. Thus, the company would be correctly valued at $32 once the effects of coronavirus have dissipated. Moreover, management continues to buy back shares and if they expand as they have been doing, the fair share price will continue to increase.

Risks

Competition:

The competition is fierce. However, RICK has differentiated Bombshells from the competition by having a military perspective, which attracts patriotic citizens, and allows them to build brand recognition. The night club industry is highly competitive. Hence, RICK aims to provide a unique experience with excellent service. The fact that they have been in business for over 3 decades, and continue to expand by opening new locations, proves that they perceive growing demand for their services and new market opportunities.

Moreover, the CEO was asked on the Q12020 earnings call about other bidders and how they approach the acquisition scenario. The CEO said this:

The trick is coming up with the cash. I mean, if you look at our next acquisition, we are putting $11 million cash down to the buyer. Now we are borrowing that money from a bank, but the seller is still getting $11 million in cash. So as far as the seller is concerned, he is getting $11 million cash county. He is carrying a $4 million note.

I don't think there are a lot of other buyers out there that have the where with all to pull up that $8 million, $10 million, $11 million cash down payments, like ours guys been able to do. Second, I think we have a great track record of closing transactions now which I think that the sellers are taking note of, our reputation on actually not only making the deal, but actually closing the transaction. And in all of the sellers they get paid and they are happy, which definitely helps I think our reputation and helps us to be able to buy just more clubs.

Industry volatility:

The business is highly dependent on the economic cycle. When this report was written, coronavirus had maintained countries on lockdown. This implies that non-essential businesses, such as restaurants and gentlemen clubs are shut down. This affects RICK's financial position in the short term, as long as their properties are shut down. Since people are being laid off, this might shift the spending priorities, affecting RICK in the long run. Furthermore, the risk of having a second peak of coronavirus cases will impact the business and would put the financial position at risk.

Conclusion

Even though coronavirus has affected the business, RICK has enough liquidity to survive under these circumstances. I believe that the company is undervalued and once the pandemic is over, business will thrive. The CEO founded the company, has been in the business for over 3 decades and currently owns 8% of the equity. Moreover, RICK has a strong real estate portfolio worth $184M. Considering that LT debt is $128M, their net real estate position is valued at $55M half of their current market cap ($110M). Adding share buybacks, acquisitions, a strong generation of cash flow and outstanding capital allocation, RICK is in a position to provide decent returns in the years to come.

Analyst’s 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.