Overview

We know of few companies with competitive advantages that trade at a ~10% FCF yield . These advantages are evidenced by a 25%+ EBITDA margin and 23% return on tangible equity. The CEO has exhibited smart capital allocation policies and has grown EPS at double-digit rates. Given both RCI’s competitive advantages and its ability to continue to grow EPS, we do not believe this business should trade at 10x earnings.

RCI Hospitality owns 40 adult entertainment night clubs throughout the U.S. This business has significant barriers to entry, as obtaining licenses to open up a new strip clubs is difficult and rarely granted, especially in RCI’s key geographies such as Miami and New York City. In fact, last month, New York passed legislation that closed a loophole under which many strip clubs in New York City were operating. This will reduce the amount of strip clubs in New York by approximately half, significantly increasing the value of RCI’s New York stripclubs—which did not use this loophole to operate—and RCI’s revenues.

In our opinion, there are two main reasons why the opportunity to buy RCI at a discount to fair value exists today:

1. The large delta between RCI’s D&A and maintenance capex makes the stock screen significantly more expensive to investors:

There are two reasons for this. First, RCI runs much of the upkeep costs through the “maintenance and repair” line item on the income statement:

Second, RCI’s nightclubs simply require less capex than a traditional restaurant or nightclub. Traditional restaurants or nightclubs are much more reliant on the physical appearance of the walls, flooring, and furniture to attract customers into the setting. Dirty restaurants will not attract repeat business. But this is much less meaningful at the majority of RCI’s adult nightclubs (only its higher end clubs like Tootsies, the NYC clubs, and a few clubs in Texas require higher upkeep). Therefore, RCI depreciates assets on a GAAP basis at a faster rate than its actual replacement capex, which creates a further delta between D&A and maintenance capex, skewing its P/E multiple.

2) At the beginning of 2016, RCI implemented a strict value-creating capital allocation policy. It has taken time for investors to adjust to and trust the implementation of this policy. However, since the policy was implemented in 2016, RCI’s share price has rallied 126%, a testament to the success of this strategy. With each day we believe investors are gaining more and more confidence in the strategy and so that gap to fair value is finally narrowing, and there is still 55% upside remaining today at this price. 

Company Background

RCI operates two main segments: adult entertainment night clubs and Bombshells.

Adult Nightclubs Business

Today, RCI Hospitality owns 40 adult entertainment clubs across the U.S. The nightclub segment accounts for 84% of RCI’s total revenues and nearly all of its operating income. 

The nightclub business is a highly stable business with minimal earnings volatility, no obsolescence risk, and significant barriers to entry due to licensing.

RCI’s nightclubs have a competitive advantage because businesses of this type are rarely granted new licenses in order to operate legally. For example, in New York, where RCI owns some of its most profitable clubs, legislation was passed the other month that prevents clubs that were operating under a loophole to stay open, making RCI’s legitimate licenses more valuable (and should soon boost RCI’s revenues as a large amount of nightclubs in New York City begin to shut down):

According to Ed Anakar, director of operations for Rick's Cabaret, which runs three clubs in Manhattan, about eight city clubs have that license. He estimated there are roughly 10 others currently operating under the 60/40 rule. They will now face closure.

"Over the years we had the opportunity to open clubs that would operate under the 60/40 rule but we refrained because there has long been uncertainty whether they would eventually be banned," Anakar said.

In reducing the field of competitors, Tuesday's decision could bolster business for the remaining clubs and increase the value of the licenses, which are tied to specific locations that have long operated as adult establishments.

"If you have a market where there are 20 businesses and half go away," Anakar said, "that's going to be a boost for the remaining participants."

More information on that can be found here:

http://www.crainsnewyork.com/article/20170607/REAL_ESTATE/170609913/city-wins-legal-battle-against-porn-shops-and-strip-clubs

Roll-up Opportunity

Given the “sin-nature” of these assets, there are few available buyers for nightclub owners who want to retire and sell their adult nightclubs. There is almost no competition to buy these assets by the likes of private equity buyers, and few people can write a check large enough and as quickly as RCI.

RCI is able to purchase clubs at a 3-4x EBITDA multiple, and the land under which these clubs are situated for an additional 2x EBITDA, for a total purchase price of 5-6x EBITDA. By financing these transactions with leverage, RCI generates over a 20% return on equity. There are roughly 3,500 to 4,000 adult entertainment clubs in the US of which only 40 are owned by RCI, giving the company a long runway to roll-up the industry.  

One example of this type of roll-up strategy is RCI’s recent acquisition of Scarlett:

RCI paid ~$26mm for Scarlett’s, which is doing ~$6mm in adjusted EBITDA, implying the purchase price was 4.3x EV / EBITDA. RCI did not need to purchase the land in this transaction since the property is under a 21 year lease. We estimate that the transaction will generate ~2.75mm in FCF ($6mm EBITDA - 0.25mm D&A - 1.25mm interest = 4.5mm pre-tax income and ~2.75mm in after-tax FCF @ 37% tax rate). $2.75mm in net income on the $10.4mm that RCI invested equals a 26% ROE on this deal.

Bombshells

Bombshells is a military-themed restaurant / sports bar. There are 5 Bombshells to date operating in Texas with two more set to open in the the next 6 months. These stores are currently company-owned stores. The Bombshells concept is similar to the Twin Peaks restaurant concept, which has ~80 locations around the United States today, or Tilted Kilt with ~70 locations in 26 states, or the nationally recognized Hooters.

More information on Twin Peaks’ success can be found here:

http://chronicle.augusta.com/news-metro-business-local-business/2015-02-13/breastaurant-business-booming-rapidly-growing-twin#gsc.tab=0

Each Bombshells restaurant does ~$4mm in revenues and should generate ~$1mm in FCF annually. The cash-on-cash returns that each company-owned Bombshell generates is ~30% and the cost to develop a Bombshells restaurant is ~$3mm.

RCI also has plans to open franchise stores. In November 2016, RCI hired Shannon Glaser, who ran the franchising division of the very successful Twin Peaks and helped the company open over 50 franchise locations during her 6.5 year tenure there. In April 2017, RCI formally launched its franchise marketing program and the company’s goal is to open 80-100 units with 70-80% of them franchised. RCI is planning to take 5.5% royalty on gross revenues for each franchise.      

We view Bombshells as a free option on the stock. The cash on cash returns on company-owned stores are so high that if any individual restaurant fails over a 3-5 year period, the investment still would have generated positive cash flow for RCI. If Bombshells continues to succeed, it could add an extra $10-20mm in annual FCF over the next decade which is not being accounted for in today’s valuation:

 Shareholder Friendly Capital Allocation Policy

As briefly mentioned earlier, RCI instituted a new capital allocation policy at the beginning of 2016. CEO Eric Langan initiated the policy after speaking with a private equity firm shareholder who helped develop the capital allocation strategy for RCI. Since then, Eric Langan has followed the principles articulated in The Outsiders (a book which he’s read twice) by focusing on maximizing free cash flow per share through buybacks. Langan will divert capital from buying back the company’s own shares, such as for acquisitions, only if it offers a return 2x greater than the FCF yield of RCI’s stock.

The strategy is very simple and is articulated in the company’s investor presentations:

*Note that the company’s FCF per share since this slide was published has increased from $18mm to $21-$22m due to RCI’s acquisition of St. Louis, Scarlett, and a new Bombshells opening.

During 2016, when the stock was trading at <$10 per share, the FCF yield was close to 18%. At that point, CEO Eric Langan used his FCF to repurchase stock. During this period, RCI repurchased approximately 8% of the shares outstanding before the stock ran up.

As the stock price appreciated into the $20 range and the FCF yield decreased, Langan redirected capital to acquiring high quality clubs in states with strong demographic profiles such as the Scarlett club in Florida, offering 25%+ ROEs as explained above.

FCF and Valuation

At the beginning of the year, RCI Hospitality guided conservatively to FCF of ~$18mm. Given their strong Q3 performance that was announced the other week, the company should generate even more than that on a same store basis.

We anticipate that pro forma for the two recent acquisitions can generate an incremental $2-3mm in FCF given that Scarlett did $6mm in adjusted EBITDA and was purchased using $15.6mm seller financed note at 8% interest ($6mm EBITDA - 0.25mm D&A - 1.25mm interest = 4.5mm pre-tax income and ~2.75mm in after-tax FCF @ 37% tax rate).

The new company-owned Bombshells should each add $1mm in FCF on a steady-state.

With all these considerations, we believe the baseline FCF is ~$22-23mm or $2.30 per share. We believe this stock should trade at least at 15x earnings, which represents a significant discount to the S&P 500 multiple given that RCI could be considered a “sin stock,” even though we think the moat for this business is at least as good as any S&P 500 company, if not stronger. At 15x earnings, RCI would be worth $34.50 or 55% higher than today’s stock price (and this excludes the free option on Bombshells). 

Additional Notes / Other Free Options on the Stock

Refinancing Debt

RCI has a fairly complicated capital structure as you can see from the below:

I’ve highlighted a total of ~$27.5mm in high cost debt. Some of this debt is up for refinancing shortly. Given where interest rates are today, as well as RCI’s new banking relationships and its greater exposure to the restaurant business, we believe that RCI can refinance much of this debt at the 6% range which would be significantly accretive. This is a free option for increasing EPS and is not included in our price target / valuation.

Non-Core Asset Sales

RCI is also in the process of selling $10mm of non-core assets. At the Sidoti & Company Spring 2017 Emerging Growth Convention, CEO Eric Langan said:

“We have also begun selling some non-income-producing properties which has generated cash. The first sale came in at a price that was in line with our expectations that enabled us to pay down $1.5 million in debt, and we anticipate the sale of 7 other non-income-producing properties we have on the block to approximate $10 million.”

This will allow the company to paydown some debt, buyback some stock, or acquire an income-producing asset. After these sales are complete, RCI will have incremental cash that amounts to  ~4.5% of the company at today’s price.

Russell Index Addition and Auditor Upgrade

RCI was just added to the US all-cap Russell 3000 and the small-cap Russell 2000. RCI also just upgraded their auditor from Whitney Penn to BDO. We believe this is an important, positive step made by the company to further increase its credibility and investor following. BDO is a top 10 accounting firm in the US by revenue—ranked 7th in 2016—versus Whitney Penn that was ranked 54th overall. More information can be found here:

https://www.cricpa.com/wp-content/uploads/2016/04/AccountingToday_Top100_2016.pdf

Major Risk:

Regulation change