How would you like to own a growing company trading at 8.3x FCF with significant barriers to entry, predictable cash flows, a healthy balance sheet, making acquisitions at 3.5x EBIT, management which owns tons of stock and a new buyback plan that could make the significant short position in the stock somewhat painful? 

  

VCG Holdings (ticker PTT) is a fast growing, misunderstood and significantly undervalued company which, pro forma for pending acquisitions, owns and operates 22 adult night clubs in 10 states.  The company trades at 8.3x 2008 Run Rate Free Cash Flow, management owns 30% of the stock, a buyback of up to 10% of the float was recently authorized, and 16% of the float is short.  The company is also underlevered at 1.9x 2008 net debt/Run Rate EBITDA and has the financial flexibility to do both additional accretive acquisitions and to buy back stock.  The company is consolidating a highly fragmented industry with significant barriers to entry, and is able to acquire clubs at a very attractive 3.5x EBIT multiple.  Integration of these clubs is relatively easy since PTT only acquires mature, established clubs and does not acquire turnaround situations.  (Note: since tables often do not come out well on VIC, www.vcgh.com is the source of much of our data.)

 

The company’s units operate under brand names including PT’s and Men’s Club.  All clubs offer total or partial nudity, the majority serve alcoholic beverages, and a small number offer full service dining.

Below are PTT’s club locations, pro forma for eight pending acquisitions. 

PTT’s strategy is to grow by acquisition since its existing clubs provide steady, predictable cash flows, its balance sheet is underleveraged, and as the buyer of choice in many situations it is able to acquire clubs at very accretive prices.  Acquisitions also help the company leverage its corporate overhead.

 

It is more beneficial to buy clubs than build them because:

a)      Acquisitions can be identified and closed far more rapidly than new sites can be developed

b)      Acquired clubs are proven, established units with strong operating track records and no development risk

c)      Existing sites maintain their permits under a grandfathered status, whereas even if greenfield sites satisfy stringent local planning rules, it is extremely rare for a new club not to encounter local community objection.

PTT’s business model is very simple, and generates steady and predictable cash flows.  The bottom line is that sex sells…always has and always will.  Adult entertainment stocks are immune from many of the risks that may impact other companies such as subprime, potentially disruptive new technology (aka someone inventing a better “mousetrap”), rising commodity costs, or a fear of outsourcing to China.  In addition, with licensing and permits for new clubs being very difficult to obtain, existing clubs have a significant barrier against new competition.

The adult night club industry is highly fragmented, being dominated by mom & pop operators who typically own a small number of clubs.  Given the evolution of the adult night club industry, these mom and pop operators are approaching an age and wealth stage where they are looking to cash out, and they are finding a very limited universe of financially and operationally capable buyers.  PTT’s management is well known and highly regarded and is the buyer of choice as they have the financial means and management infrastructure to close deals quickly. The larger, private industry players do not have the reputation or financial wherewithal to be active buyers, and there is only one other publicly traded player in the space, Rick’s Cabaret (RICK).  And with an estimated 2,500 clubs across the US that are subject to consolidation, and PTT and RICK currently having approximately 20 units each, there is plenty of room for both to coexist without bidding against each other.  We have seen no evidence of upward pressure on the target acquisition multiples and PTT’s acquisition pipeline remains full.  

 

PTT management sees a significant pipeline of acquisition opportunities and would be disappointed to do less than $30mm of acquisitions in 2008, after doing a projected $57.5mm of acquisition in 2007. Acquisitions through 2007 include:           

The acquisition model is not dependent upon PTT realizing operating improvements. Nonetheless, PTT can often bring its broader experience to a new club to improve floor layouts, extend operating hours, expand and improve any restaurant operations as well as share other best practices.   As an example, their recently acquired Minneapolis-St. Paul club is only two blocks from the Minnesota Metrodome, the stadium for the Twins and the Vikings.  Previous owners did not open the club on Sundays and thus missed out on substantial “sports” traffic.  PTT will open the club on Sundays and expects this to have an immediate impact on profitability.  The recently acquired Raleigh club has an undermanaged restaurant that can benefit from the application of PTT’s expertise in restaurant operations.

We have analyzed PTT under four different EPS scenarios, as follows:

-         2007 Adjusted GAAP guidance of $0.46, excluding 3c non-recurring items for acquisitions;  This will be a reported, not pro forma, figure and assumes no acquisitions in 2008.

-         2007 Pro Forma Run Rate of $0.36 presuming no additional acquisitions beyond those closed as of June 30, 2007.  This unrealistically assumes eight pending acquisitions do not close.  If for some reason some of the acquisitions fall through (we have no reason to believe they will), we believe there are many other acquisitions the company could make instead.

Scenario 3

-         2008 Pro Forma Run Rate of $0.68.  Assumes PTT owns existing clubs and eight pending acquisitions as of Jan 1, 2008, but assumes no additional acquisitions in 2008. 

Scenario 4

-         2008 Pro Forma Run Rate of $0.88.   Assumes PTT owns existing clubs, eight pending acquisitions, and $30mm of additional acquisitions as of Jan 1, 2008.  The company expects to make more than $30mm of acquisitions in 2008, but the timing of such acquisitions is difficult to estimate.

 

Scenarios 1 and 2 are unrealistic and do not give full impact for planned acquisitions.  Those EPS give no credit to the reality that if PTT were not to do additional acquisitions, it would do a big (and accretive) recap.  Scenario 3 is the most realistic scenario and what we have based our investment thesis on.  Scenario 4 is intended to give a roadmap for what the company can generate when it completes add-ons in 2008.

 

We are more free cash flow focused than EPS focused.  PTT’s cash tax rate will be 27% (vs. 34% book for the foreseeable future due to goodwill accounting).

-         2007 Adjusted GAAP guidance of $0.46

The stock has been beaten down in part because management recently lowered 2007 EPS guidance from 62c to 46c.  The 46c excludes 3c of non-recurring acquisition charges.  However, we believe 2007 guidance is irrelevant since its does not give pro forma effect to several highly accretive and recently closed/pending acquisitions.  This business has limited SSS growth and is fairly easy to predict.  The reduction in 2007 guidance came about not because of any weakness at their clubs but because management overestimated the number of deals it would close in 2007.  PTT continues to have a robust acquisition pipeline, however acquisitions in 2007 took longer than anticipated to negotiate and close and management was stretched too thin to close as many as intended.  The company has now built out its finance and accounting infrastructure including the hiring of a new CFO while retaining the previous CFO to focus on acquisitions.

 

-         2007 Pro Forma Run Rate of $0.36 presuming no additional acquisitions beyond those closed as of June 30, 2007 (assumes eight pending acquisitions do NOT close)

Shorts argue that PTT is a build up story and the company will not be able to find additional accretive acquisitions.  This is factually incorrect, but assuming the short case is correct and the company does not close any more acquisitions, including announced acquisitions, we have looked at the company’s pro forma results only including clubs they currently own. 

 

If no acquisitions were closed beyond Q2, at a normalized tax rate of 34% (versus the lower tax rate used in Q2 due to expiring NOLs), Run Rate EPS would be $0.36, and Run Rate Free Cash Flow per share would be $0.41.  Under this scenario, PTT would be trading at a PE multiple of 17.2x and a FCF multiple of 15.0x.  However given the large number of acquisition opportunities available to the Company, we consider this case highly unlikely.

Scenario 3

-         2008 Pro Forma Run Rate of $0.68 including the eight pending acquisitions through December 31, 2007 (assumes no additional acquisitions in 2008)

We point out that the revised 2007 EPS guidance number of 46c is an adjusted reported estimate, not a PF or run rate figure, and does not reflect the core business including the significant and accretive acquisitions that have and will close through the year.  Going forward, management has provided enhanced clarity on the company’s earnings power as it enters 2008 by outlining a roadmap to a 2008 EPS Run Rate of $0.68, which includes PTT’s existing 14 clubs plus assumes the 8 pending clubs are acquired by January 1, 2008. 

 

The following table shows the company’s:

-         Estimated Reported Q2 EPS

-         Pro forma Q2 EPS (pro forma for two acquisitions that closed during Q2)

-         Quarterly and Annualized Run Rate EPS (run rate for the eight pending acquisitions)

 

 

The following table shows the bridge from the company’s Pro Forma Q2 EPS to its Quarterly Run Rate EPS, identifying the impact of the 8 pending acquisitions.

 

The 2008 Run Rate EPS estimate of 68c ($0.17 x 4) is also very conservative because, contrary to explicit company strategy, it does not assume any further acquisitions.  Management has indicated that they would be disappointed to do less than $30mm of acquisitions in 2008.

 

 

At the current market price of $6.20 (8/8/07), the table of FCF multiples shown below demonstrates how significant the implied undervaluation of PTT’s stock is.

 

Scenario 4

-         2008 Pro Forma Run Rate of $0.88 including the eight pending acquisitions through December 31, 2007 and $30mm of additional acquisitions in 2008

Management has provided a more detailed explanation of their acquisition model that describes the run rate scenario given various levels of additional acquisitions in 2008.  As shown below, under an expected acquisition scenario of $30mm, with 10% (conservatively) assumed debt financing costs, 3.5x EBIT purchase prices, and a 34% gaap tax rate, the company will achieve a Run Rate EPS of $0.88.  Leverage at this level of acquisitions remains a moderate 2.3x.  Again, management has indicated that they will be disappointed to do less than $30mm of acquisitions in 2008, but they do not provide specific EPS guidance because the timing of closings is unpredictable and they want to under promise and over deliver.

 

 

2008 estimates do not include any SSS growth since most units are mature stores, nor does it give credit to the big boost generated through having clubs in both cities where the 2008 Democrat and Republican national conventions will be held (Denver and Minneapolis-St Paul).  This analysis also does not give credit for the operating leverage achievable against corporate overhead as PTT buys more clubs.

 

On July 31, the company authorized a buyback of up to 1.6mm shares, or almost 10% of the float, a testament to the company’s view that the stock is currently undervalued.  We believe the company is eager to begin the buyback, but is in a blackout period until the 10Q is filed, due August 15.

 

The company is subject to a non-compliance warning (note: this is NOT a delisting notice) from the Amex, relating to their failure to file timely listing applications for the issuances of shares prior to February 2007.  Later this week the company plans to file an 8K for the Raleigh, NC, acquisition at which point all filings will be current and the warning should be removed.  Then, the company intends to move to the Nasdaq.

PTT has conservative, capable management whose 30% stock ownership aligns its interests with that of other shareholders.  Earlier this year, Troy Lowrie, CEO, contributed his six privately held clubs to help the company achieve a critical mass and it demonstrates his commitment to the long term goal of building a dynamic, public player in this industry.  Troy no longer privately owns any clubs.

 

The management team is very experienced and savvy, and runs their clubs in a highly professional manner.  Troy’s father was involved in the industry and Troy essentially grew up in the industry.  No drugs or prostitution are permitted and the company has a reputation for providing the dancers with a safe working environment.  The company has augmented its accounting and finance and acquisition function during 2007, with the hiring of additional professional staff and in July hired a new, more experienced CFO.  The previous CFO has been retained as Chief Accounting Officer and will focus on acquisitions. 

 

To demonstrate that PTT management is mainstream professional and not what you might expect in this industry, google Michael Ocello, PTT’s COO, who was recently elected to the School District Board of Education in the conservative, suburban, south St Louis County in Missouri.   

 

In the spirit of full disclosure, Hal Lowrie, who passed away in 1994, was involved in some legal difficulties which you can google. Hal Lowrie was the founder of predecessor entities to PTT and father of the current CEO Troy Lowrie.  Our due diligence has found no problem with the CEO or any other members of management. We note again that the CEO holds 30% of the company’s stock and does not draw a salary.

PTT is covered by Merriman, although we suspect that it gets only low priority attention at this stage, and by Montgomery Street Securities.  

There is a big short position, so it is worthwhile to address the short thesis:

1)      The stock is overvalued

a.       Stock trades at 8.3x Run Rate FCF

b.      If we are overly conservative and assume none of the announced acquisitions close (which is an unlikely scenario), stock trades at 15.0x annualized  Run Rate FCF based on the clubs they owned as of June 30, 2007

 

2)      PTT must issue equity to finance acquisitions

a.       As illustrated earlier, the company has significant debt capacity and will not have to issue to equity to finance acquisitions for the foreseeable future

 

3)      Current low tax rate is unsustainable

a.       This is true; however, in the company Run Rate estimates, the company is modeling a full 34% book and 27% cash tax rate

 

4)      There are no more attractive acquisitions available

a.       Our conversations with industry contacts confirms management’s assertation that there are plenty of acquisition opportunities

 

5)      Management is weak

a.       Admittedly, management was overextended given the tremendous growth it experienced.  To address this problem, the CEO has improved infrastructure by, among other things, hiring a new CFO and retaining the former CFO to focus on acquisitions, and adding other support staff.  What shorts fail to realize is that this is a relationship business and the CEO has been in this business his entire life and is well known and highly regarded in the industry.  As a result, PTT has access to many attractive acquisition opportunities

 

6)      Management are crooks

a.       While the CEO’s father admittedly had some legal problems, he passed away in 1994 and the company’s current management team is clean.  The president is on his local school board in the ultra conservative Missouri.  Management runs a very legitimate business because they know if they break the law (allow prostitution for example) they could lose their license to operate.  The CEO doesn’t take a salary and management owns a lot of stock personally.

It’s difficult to determine what an appropriate value would be for PTT.  Comping against restaurant companies may be appropriate, but PTT doesn’t face commodity pressures, changing consumer preferences, minimum wage issues or much competition.  PTT is also faster growing.  On the other hand, PTT is smaller and less liquid than most restaurant companies and is a player in non-mainstream industry (although gaming and waste management both moved beyond that).  We will let you determine what an appropriate multiple is.  We just feel its current multiple is dramatically too low.  In terms of other comps, the only publicly traded comp is RICK, which has inferior management and buys clubs that often require turnarounds.  RICK trades at 10.5x FYE Sept 2008 EPS (8/8/07), but we caution that this is based on a Merriman research report and we don’t feel the analyst is very up to speed on RICK or PTT.