Description

We believe we will at least double our investment with RICK. In RICK shares one can find a close (legal) analog to the oldest profession in the world priced to go out of business in a few years. We disagree with the market, view RICK's current price as deeply undervalued and have identified specific near-term catalysts for revaluation.

THESIS SUMMARY

Despite strong cash flow and its status as the industry's best operator, we think RICK's equity is undervalued due to challenged optics. RICK's EBITDA margins are more than double VCGH, its largest competitor that recently went private at >2x RICK's current EBITDA multiple. We believe that RICK maintains leading margins due to its scale, strict cash management and integrity of operational / accounting controls. Operating cash is nearly $1.5m/month and recurring maintenance capex is minimal resulting in <5x normalized FCF. Despite these dynamics, RICK has been optically challenged: 1) RICK made a disappointing 2008 acquisition of a Las Vegas club that burned cash from day one and has since been closed and written off. Removing losses from this club over the last 11 quarters reveals trough op margins above 20% resulting in earnings substantially greater than reported; 2) Same Store Sales were down in the low single digits during 1H11. Excluding Vegas however, SSS were up 9.5% on average; 3) In late August, the TX Supreme Court upheld a state law requiring adult nightclubs to pay a "Pole Tax" of $5 per club visitor sending RICK's shares down nearly 10%. RICK had already been fully accruing this expense and therefore will experience no earnings impact and only a potential small future cash flow impact going forward of ~ $700k per quarter which we've baked into our cash flow analysis; 4) the firm's auditor compels RICK to allocate the land portion of club acquisitions to capex substantially reducing headline yield and masking the strength of RICK's sustainable cash flows; 5) RICK had experimented with "lock-up, leak-out" deals whereby stock was issued for acquisitions with put options for sellers to liquidate over time. As RICK's stock price declined this became an issue but the maximum liability is less than $4.0m even contemplating a $0 stock price. 

COMPANY DESCRIPTION
Houston-based RICK owns and operates 22 upscale adult nightclubs located in Texas and select Midwest and East Coast locations. Operating under the Rick's Cabaret, Onyx and XTC trademarks, RICK has grown through acquisition into the largest adult nightclub operator in the United States. In addition, RICK owns and operates various adult entertainment websites as well as industry trade shows and publications. Management and insiders own 15% of the company and the company has been repurchasing shares under its $5m authorization.

Rick's Cabaret clubs tend to be more upscale while XTC is casual and Onyx caters to the well-to-do segment of African Americans. While regular nightclubs have a sometimes <1 year lifespan, RICK's first adult nightclub remains a money maker and has been around for nearly two decades.

RICK generates 45% of total revenue from "service" which includes cover charge, house fees, VIP room fees and credit card administrative fees. The entertainers are independent contractors that pay the individual clubs a house fee to work in the club on a given day. The amount varies by location, day and time (e.g. $180 in New York after 10pm on a Saturday). The girls keep money from dances and Tips. The service fees drop almost entirely to the bottom line and as the clubs fill up patrons spill into the VIP room which is pure incremental margin for RICK. The next largest line item is alcohol sales which represent roughly 40% of overall revenue. The majority of RICK's clubs serve alcohol however there are 5 clubs that are BYO and we expect the new DFW club will secure its liquor license in the near future.

The company's cash management system is based on the casino model - the bar tender is given a drawer at the beginning of a shift, counts money in front of cashier at the end of the shift; both sign off and the amount is immediately flashed to Houston. Bottle inventory is strictly managed comparing actual pours to expected pours. Girls are independent contractors that provide their thumbprints upon sign-in. Club managers are isolated from, and do not handle any cash. Each club's cashier reports directly to the CFO or his deputy in Houston. The CFO has video systems that allow him to view any cash register in the network at any time through an iPad or computer in real time. Customers are compelled to give their thumbprints to make sure use of the credit card is authorized limiting bounce-backs from the card issuers and resulting in over 60% of the business being transacted with credit. RICK leverages its scale with national and regional deals - liquor, table linens, restaurant supplies, food, marketing expenses, etc.  

RICK has a "no-tolerance" policy as to illegal drug use in or around the premises. Club management conducts periodic unannounced searches of entertainers' lockers and once entertainers and waitresses arrive for work they're not permitted to leave the premises without permission (or they cannot return to work until the next day).

THESIS DETAIL
Despite sustainable free cash flow and its status as the industry's best operator, we believe RICK's equity is undervalued due to challenged optics. RICK's EBITDA margins are more than double VCGH, its largest competitor that was recently taken private at more than twice RICK's current EBITDA multiple. We believe that RICK maintains attractive margins due to its scale, strict cash management and integrity of operational/accounting controls. Operating cash is nearly $1.5m/month and recurring maintenance capex is minimal. Nonetheless, RICK has been optically challenged recently due to:

1) RICK acquired Scores-Las Vegas ten days before Lehman filed for bankruptcy. This club burned cash from day one as overall occupancy dried up, casinos were aggressive in keeping visitors on the strip and requisite kickbacks to Taxi drivers compounded as competition intensified. This club was, for all intents and purposes, closed and written down in F3Q11. Adjusting for the losses from this single club over the last 11 quarters reveals trough op margins above 20% resulting in earnings substantially greater than reported. 3Q11 is only our first look at adjusted margins and we'll see three years of data ex-Vegas once the 10-K is released in December. In addition, RICK will receive a $4m cash tax-loss carry back from the IRS related to losses at this club.

2) Reported Same Store Sales were down in the low single digits during F1H11. Adjusting for Las Vegas however, quarterly comp store sales were up 9.5% on average:

3) In late August, the TX Supreme Court upheld a state law requiring adult nightclubs to pay a "Pole Tax" of $5 per club visitor sending RICK's shares down nearly 10%. RICK had already been fully accruing this expense and therefore will experience no earnings impact and a small potential cash flow impact going forward of roughly $700k per quarter - if RICK ultimately has to pay (see below).

As a background: beginning 1 January 2008, RICK's Texas clubs became subject to a new state law requiring each club to collect and pay a $5 surcharge for every club visitor. A lawsuit was filed by the Texas Entertainment Association (TEA) on the grounds that the fee was an unconstitutional tax. On 28 March 2008 a State District Court Judge ruled that the Pole Tax violates the US Constitution's First Amendment. The State appealed the ruling. On 5 June 2009 the Court of Appeals agreed with the State District Court Judge - that the tax was unconstitutional. The Texas Attorney General then asked the Texas Supreme Court to review the case. On 26 August 2011, the Texas Supreme Court reversed the judgment of the Texas Court of Appeals by saying that the Fee does not violate the First Amendment. The case was remanded back to the District Court. The media has reported this decision as a win for the State however, this is not necessarily the case. Remanding this back to the lower court puts the TEA (and RICK) back on first base and it'll be several years before a final decision is made. In the meantime, there is a standstill agreement which says that Texas cannot collect the tax until the litigation is finalized. RICK had expensed and paid the first five quarters from 1 January 2008 under protest. In subsequent quarters, RICK accrued the fee but did not pay the state. As such, our ultimate valuation derived from a conservative DCF takes this tax into account and still renders 99.9% upside. The total liability is $6.1m.

4) RICK's auditor compels the allocation of the land and equipment portion of acquisitions to capital expenditures substantially reducing headline yield and masking the strength of RICK's normalized free cash flow.

RICK typically pays 3-4x EBITDA for a club (potentially on the lower end currently given the status of the markets). RICK also attempts to purchase the land in order to not have to negotiate with landlords. RICK owns the majority of the properties on which the clubs reside.

5) RICK had experimented with "lock-up, leak-out" agreements whereby stock was issued for club acquisitions with monthly put options struck at contemporaneous prices for sellers to liquidate slowly over time. As RICK's stock price declined from the mid-$30 range these agreements became substantially dilutive. The dilution obviously comes from the difference between the strike on the put and the current stock price. To figure out the maximum liability however, we contemplate a $0 stock price at which point the obligation would be $4.0m. The liabilities outlined in RICK's most recent 10-Q were calculated at an $8.44 share price:

We're also given the information that each $1 per share movement in stock price has an aggregate effect of $168k on the total put obligation. Backing into the number implies an average $24 strike. We have never seen an arrangement like this and believe it fits the description of challenged optics as many investors probably haven't seen this before. While management characterizes these agreements as interest free debt, they've also conceded to us that they'd never consider this type of arrangement again.

VALUATION
Adjusting Enterprise Value to reflect moving pieces on the balance sheet, RICK trades for less than the aggregate value of its acquisitions even after excluding the botched Vegas deal. This is despite substantially improving operations and profitability at many of the clubs. In speaking with CEO Eric Langan, his belief is that RICK could sell their top two performing clubs (New York and Miami) for more than the company's current market cap.

We adjust the Enterprise Value to reflect moving pieces on the balance sheet:

RICK's convertible debentures, warrants and options dilute basic shares by roughly 900k at our target price. The majority of the debt on RICK's balance sheet is mortgage / property related debt and is collateralized as such. Some of the debt is guaranteed by Eric Langan (CEO) himself. 
 
Even during the darkest quarters of '08/9 RICK's comp store sales and margins held up relatively well. During the "recovery" in '10 RICK's EBITDA margin recovered to 25.1% while VCGH's declined to 13.4%. VCGH was taken private by its founder in April for 8.5x EBITDA. RICK trades for just 4.0x FY11 EBITDA. Applying the VCGH multiple implies 150% upside.

We rely on our conservative DCF however, which renders a diluted value per share of $12.69 or 99.9% above today's level and representing 7.3x EBITDA, 14.9x earnings and 10.1x normalized FCF.

We believe that our DCF is conservative for a number of reasons, most notably because we're assuming that EBITDA doesn't reach the levels achieved in 2011 in subsequent years. This is despite an expected $3+ million boost from Philadelphia and DFW, in addition to two other clubs acquired this year and strong comps and continued tuck-in acquisitions. If we assume that 2011 EBIT is sustainable and add another $4.0m from DFW, Phili and two other '11 acquisitions our DCF renders 140.0% upside.

CONCERNS

Catalyst

1) October 2011: Two of RICK's clubs, Philadelphia and Dallas/Fort-Worth are going to experience substantial increases in operating income. In Philadelphia, a ban on late-night alcohol sales crimped income but has been lifted. At the new DFW club, RICK had won its protest hearing related to the issuance of its liquor license and the 20 day appeal window has come and gone. Management expects to have their liquor license at DFW by Halloween. If RICK's ultimately secures their liquor license at DFW, we believe this club will add an incremental $3m of operating income per annum at maturity (~12-18 months from now). Given that we model $16m of adjusted EBIT this fiscal year, that's 18.5% organic growth with no additional capital outlays.

2) December 2011: The release of the 10-K in December will cover the Post-Lehman recession time period and reveal the strength of trough op margins excluding Las Vegas (which they purchased just a few weeks before Lehman collapsed).

3) Next 12-18 months: We believe that RICK is working on a credit facility to be collateralized by owned-land for future acquisitions. If they ultimately are unable to finance substantial continued growth, we believe the board will institute a sustained dividend and leave enough cash for continued tuck-in acquisitions. We contemplate the size of a dividend yield based on 25% of normalized 2011 free cash flow which results in a 5.4% yield at current prices - relatively high for what we believe to be a stable long-term cash flow profile.