It’s rare to come across a business generating an FCF yield of +10% (and growing). That’s the case of RCI Hospitality (Nasdaq: RICK), a company that operates nightclubs (aka strip clubs) and restaurants in the US.
In a world of zero interest rates, a business producing a double-digit FCF yield begs the question why does this opportunity exist?
It’s a combination of two factors:
The stock doesn’t attract institutional capital. RICK is a microcap that recently had troubles filing its financials on time. Moreover, the company’s business lines contain too much headline risk. Most institutional investors don’t want a piece of that.
The balance sheet doesn’t screen well. RICK has a net debt of ~$130mm and a pre-COVID debt/EBITDA ratio of ~3.5x.
Luckily, these two items present constraints that don’t concern me.
I’m not worried about RICK’s business lines—it’s a free country—, investing in microcaps is an advantage for the individual investor, and I think RICK’s reporting problems are minor.
In addition, RICK’s debt appears worse than it is. Contracting debt is part of the company’s strategy, and more than 80% of it is guaranteed by real estate.
RICK’s nightclubs segment is attractive because it’s high-margin, asset-light, and there is a long runway for growth through accretive acquisitions. RICK’s restaurant segment is attractive because it has healthy margins and the potential to expand with a franchise model.
The investment case for RICK is also compelling because management has an “outsider” capital allocation mentality. The company has a framework for buying back shares, reinvesting in the business, or paying down debt depending on its FCF run-rate and market circumstances.
Smart capital allocation matters. Since 2015, RICK’s FCF/share has grown at a clip of ~25% per year, but the stock is trading at a pre-COVID-19 trailing EV/EBITDA of <8x.
I think the stock is conservatively worth +$32/share.
I always thought Beyonce was part of this
Cabarets Are Cash-Generating Machines
RICK operates 38 nightclubs in the US under different brand names, such as Rick’s Cabaret, Scarlett’s, and Club Onix. The nightclub segment is responsible for ~80% of the company’s total revenue.
Nightclubs are an attractive business because they generate so much cash. On average, RICK generates ~$4mm a year in sales in each club. Most of that is comprised of service revenue (paying to enter the club) and alcoholic beverages. Service revenue is a 99% gross margin item, while alcohol is an ~80% gross margin item. Maintenance CapEx is low: it encompasses maintaining carpets, chairs, lights, some cameras—all in the context of a poorly lit environment. There’s no need for fancy stuff. The staff is mostly compensated through tips.
Considering operating expenses at the segment level, RICK can sustain a 4-wall ~30% EBIT margin.
The heat death of the nightclub universe
A point of concern is a potential decline in the nightclub business. While market research indicates the market is growing, this growth seems to be deaccelerating at a fast pace.
Over the long-run, it’s fair to assume the industry will contract. Modern society isn’t the most receptive to nightclubs culture. Millennials don’t like them. There’s competition from online porn. Regulations are tightening.
Yet, it may take years before extinction occurs. Nightclubs are part of the sin industry for they exist to satisfy the natural impulses of men. Similar services have existed in different societies throughout the centuries.
Counter-intuitively, investing in a business that’s in a declining industry doesn’t always make for a bad investment—it could be quite the opposite.
The foremost example is that of tobacco stocks, some of which are among the best-performing stocks over the last few decades. Consolidating the industry, maintaining high-margins by improving operational efficiency, leveraging scale economies, exerting pricing power, and returning capital to shareholders through smart capital allocation help explain those tobacco returns.
A declining industry offers opportunities for larger players. Tighter regulations benefit big players and smaller operators sell-out at attractive prices. In this instance, RICK is in a good position.
Growing in a declining industry
There are ~2,200 clubs in the US, 500 of which meet the RICK’s investment criteria. With 38 clubs and ~$150mm in sales, RICK has a ~2% share of a market that’s worth $8bn.
RICK’s expansion strategy is accretive. The company buys nightclubs at 3x to 4x EBITDA. FCF conversion from EBITDA is high, leaving the company with a +25% cash on cash return.
RICK can buy nightclubs at such an attractive price because there is a dearth of buyers. There is no competition from private equity as institutional investors don’t want in. Most other operators don’t offer significant competition—especially for larger deals—as they generally have no access to debt financing and can’t come up with the upfront cash to close a transaction. Moreover, operations in this business don’t scale rapidly; you need experienced managers to run clubs efficiently.
Usually, RICK purchases the nightclub and the real estate associated with it. The company finances that real estate with bank debt. A portion of the transaction may be financed with a sellers note, and the business is given in guarantee for that payment. As such, RICK pays the seller with the cash flow generated from the business itself, reducing upfront investment and boosting equity returns by means of leverage.
Competition
The market is fragmented. According to RICK, the top 5 players in the industry likely have less than 15% share of the total market. None of RICK’s competitors are publicly-listed. Large competitors include Deja Vu, MAL Entertainment, and Spearmint Rhino.
Given this fragmentation and the large market opportunity for buying smaller operators, competitive pressures don’t pose an immediate threat to RICK’s growth.
Girls, Girls, Girls
RICK also operates 10 restaurants in Texas. The company entered the business in 2013 by opening its first Bombshells. This segment now represents ~20% of the company’s sales.
Bombshells is a restaurant & bar with a military theme and servers dressed provokingly. It’s a breastaurant, similar to Hooters. Bombshells are large restaurants with patios, usually located by the side of a highway in a free-standing pad site, with plenty of parking space. There are large screens across the restaurant so people can watch sports. It’s more of a partying concept, as 60% of sales come from beverages and 40% from food.
The unit economics of Bombshells are attractive. They generate $4-$5mm a year in sales, with EBIT margins of ~10%.
The company doesn’t segment pre-opening expenses from regular operating expenses. Because RICK was expanding Bombshells from 5 stores in 2017 to 10 today, EBIT margins may not reflect what the company could achieve on a normalized basis. Management has a target of 18% to 21% operating margins for Bombshells. Most recently, in Q3/20 (ended June 30, 2020) RICK achieved a 22.3% EBIT margin.
EBITDA margins in the casual dining business range from 9% to 23% at the company-level. At the unit level, they can reach +30%. RICK’s EBIT margin target is achievable, especially considering the restaurant’s mix of high-margin alcohol sales.
Operating a restaurant is different from operating a nightclub, and RICK’s management is on a steep learning curve. Recent quarterly results indicate that Bombshells’s operations are getting smoother.
RICK now stopped further expansion as it re-evaluates its Bombshells strategy preparing for its next steps. Management wants to make sure it’s achieving a high rate of return on this investment; the goal is to structure investments such that new units obtain a 25% to 33% cash on cash return.
This expansion pause should help increase the focus on operations so that the full potential of Bombshells becomes clearer.
Casual dining competition
Not a lot to look here. There are many casual dining companies, such as Red Robin, BJ’s, and Dave & Buster’s. They all try to differentiate their restaurant brands based on the type of food they serve, environment, price points, etc.
I think it’s hard to have a competitive moat in this space. It’s more about providing a differentiated value proposition (a theme, for example) and operating the restaurants effectively.
Bombshells compete by being located in A areas, with lots of space, patios, parking, large screens for watching sports, and its servers. It’s all fair game. Although this is not an innovative business, it’s a profitable one if operated and scaled correctly.
Land and sell
RICK’s expansion strategy for Bombshells starts with buying an undeveloped land site. The company then develops the site, provides basic infrastructure, divides it into smaller parcels (one of which will be occupied by a Bombshells), and sells the excess land. There’s the potential to gain on excess land sales (businesses pay more dollars per square feet for smaller-sized lands), but also to attract more traffic to the site by bringing other businesses to the area.
As with nightclubs, RICK uses debt to finance the purchase of the property. The sale of excess parcels is used to amortize this debt.
Growth opportunities
Management believes there’s the potential for 100 Bombshells throughout the US. Right now, Bombshells are located only in Texas; the next step would be to expand to Florida.
If the concept is successful, there’s an opportunity for growth through franchises. Management’s target is to have ~20% of company-owned stores, and ~80% operated by franchisees.
The franchise opportunity adds incredible upside potential. I don’t know what would be the specific economics of a Bombshells’s franchise, but I like the high-margin and asset-light idea of collecting franchise royalty streams.
Here’s a nice thought: 80 Bombshells generating $4mm in gross sales per year, for a total of $320mm. Let’s ignore fixed fees. A 5% royalty fee could add $16mm in annual FCF for RICK. This FCF alone would justify RICK’s current valuation.
Capital allocation matters
RICK has a clear capital allocation framework. The company considers its cost of capital to decide whether to buy back shares, pay down debt, or reinvest in the business by acquiring nightclubs or opening Bombshells. If the stock yields +10% based on the company’s free cash flow run-rate, management will buy back stock.
Over the last five years, though executing buybacks and paying dividends, the company has mainly reinvested in the business.
The company’s capital allocation decisions—including buying high-performing nightclubs, closing down underperforming locations, and expanding Bombshells—have yielded results. RICK has grown sales and expanded margins.
This growth, coupled with strategic buybacks, have significantly increased free cash flow per share from $1.43/share in FY2015 to $3.45/share in FY2019.
Management & Ownership
Eric Langan is RICK’s Chairman and CEO. He’s been with the company since 1998 when his nightclub was acquired by RICK and he became a Director and Officer. He holds ~8% of the company.
I see Eric as an owner-operator. I like that. A common theme in my investment decisions is to buy companies led by their founders (or quasi-founders) because they know the business and are highly invested in it, financially and emotionally. Revolve (RVLV), Duluth (DLTH), and Tesla (TSLA) are good examples of that.
RICK adopted its capital allocation framework circa 2015 as Eric was inspired by reading the book The Outsiders. It’s a classic book in investing circles. I couldn’t agree more with RICK’s capital allocation decision since then. The fact that management changed its strategy and focus from growth to capital allocation shows good judgment.
ADW Capital, an activist fund led by Adam Wyden, holds 9.99% of RICK. Here’s a nice interview with Adam so you get to know him. I think ADW built its position in RICK more recently, over the last three or four quarters. Adam sees value in RICK, especially in Bombshells, and he wants to unlock it.
Just now, researching for this write-up, I discovered that Greenhaven Road is also an investor, with 5.5% ownership. I’ve never read about this investment in any of Greenhaven’s letters, so this might be new. You may remember Greenhaven from my write-up on SharpSpring (SHSP).
I’m mentioning these two investors because I admire them and I think they provide a healthy investor base for RICK—they’re usually not interested in making a quick buck; they’re in for large gains and the long haul. Based on Adam’s questions on the past couple of RICK’s conference calls, he may also help steer management in a good direction. Let’s see what happens.
A quick note on RICK’s filings delays, the opening of an SEC investigation on the company, and short-seller allegations: it’s all minor. RICK had some troubles with its accounting systems, but they were solved. The company also had some disclosure problems regarding related-party transactions. These transactions were minor and seemed reasonable after they were disclosed. I think some investors, notably short-sellers, are making a big deal out of small issues.
You can read more about these allegations and problems here, here, here, here, here, and here.
Valuation
First, some general observations:
RICK doesn’t disclose maintenance CapEx per segment, but the number is 2x to 3x lower than depreciation and amortization. Being extra cautious, I consider D&A as equal to maintenance CapEx.
The company maintained a neutral working capital position (that is, current assets roughly equal to current liabilities) over the last five years. I assume no further investments in working capital.
Because RICK owns most of the real estate that lodges its operations and this real estate is given in guarantee to the company’s debt (it’s basically a giant mortgage), true operating earnings must consider the payment of interest expense as part of RICK’s cost of occupancy.
More than 80% of the company’s debt is guaranteed by real estate. That’s a good thing because banks have valued those properties and performed due diligence. Because the loan-to-value ratio is lower than 80%, I consider that RICK’s real estate value is roughly equal to its total debt.
I use a sum-of-the-parts, back-of-the-envelope valuation.
RICK’s nightclubs generated an average of $3.9mm in sales per unit in FY2019. EBIT margins have expanded over the last five years as the company implemented its capital allocation framework and started to focus on more profitable clubs. In FY2019, the company achieved an EBIT margin of 34.1%, up from 26.3% in FY2015.
RICK has 38 nightclubs, so it’s easy to imagine the segment generating ~$150mm in sales every year, with +$45mm in sustainable operating earnings power.
Bombshells generate ~$4.5mm in sales per year per unit. EBIT margins have recently expanded to +20%, but have historically been ~10%. This number doesn’t exclude pre-opening expenses. It’s fair to admit that these expenses have some weight on the company’s margins since RICK was doubling the number of restaurants over the past 2 years. Management targets margins of 18%-21%, which is reasonable based on comps.
RICK has 10 restaurants which should generate ~$45mm in sales a year, with +$7mm in sustainable operating earnings.
RICK’s total debt is $142.7mm with an average weighted interest rate of 6.55%. Considering the tax shield, interest expense per year should amount to ~$7.2mm.
Finally, corporate overhead in FY2019 was 10.2% of sales, which is roughly equal to the company’s five-year average. That amounts to ~$18.5mm a year.
Altogether, the business generates +$20mm in free cash flow to equity a year using conservative assumptions. In FY2019, RICK generated +$30mm in FCF.
Assuming no growth, the business is worth $200mm, or ~$22/share.
Terminal growth of 3% (remember RICK’s 5-year track record of 25% CAGR FCF/share growth) yields a value of $32/share.
My DCF valuation, using similar assumptions, results in $33.80/share. $32/share is a good ballpark number.
Note that my valuation disregards most of the levers RICK can pull to drive accelerated growth: the acquisition of more (and larger) nightclubs at 3x to 4x EBITDA and the potential expansion of Bombshells.
COVID-19
COVID-19 won’t last forever. Things will eventually normalize. I expect that to happen sooner (12 to 18 months) rather than later.
During the pandemic, RICK had to close both nightclubs and restaurants. However, because the business is capital-light, the company still managed to generate a positive free cash flow of ~$800k in the first half of 2020.
Now, nightclubs and restaurants are re-opening. Although operations aren’t fully normal, the company is getting back to growing FCF.
Conclusion
RICK generates large amounts of free cash flow relative to its equity value. The company appears to be leveraged, but its total debt is a function of a strategy to acquire commercial real estate.
The business is asset-light, margins are healthy, and growth opportunities are plentiful. RICK’s management knows how to operate its business—and it’s not an easy one. Most importantly, the company is laser-focused on capital allocation. I like the simplicity of RICK’s easy-to-follow capital allocation framework.
With FCF/share growing double-digits and a stock trading at <10x FCF, this opportunity is just too good to pass. I’ve bought some.
Risks
Lawsuits; Large debt that needs to be rolled-out; Assets only cover debt; COVID-19; Succession (who could replace Eric if needed?); Activist pushing the company to the wrong direction
Next Steps
I’ll keep an eye on the following:
Average sales per unit (nightclubs and Bombshells);
EBIT margins per segment;
Operating expenses (should decline as % of sales);
Evaluation of Bombshells returns;
Bombshells expansion through new corporate-owned stores or franchises;
Acquisition of new nightclubs;
Capital allocation decisions (buying back shares or reinvesting in the business?);
FCF/share evolution.
Please leave a comment if you disagree with me. You may also leave a comment if you agree.
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