Money & Sex on the Exchange

19 Jan

*All links are to investor related materials.

Life is a Cabaret! Most men know how much to pay for a lap dance, but do investors know how much to pay for the companies that provide the facilities for the shapely young entrepreneurs? People often point out that it pays to own “Sin Stocks” like alcohol and tobacco producers. However, few mention “adult nightclub” owners.

 

The industry is highly fragmented with most owners having only one nightclub. There are several publicly traded nightclub owners, Rick’s Cabaret International Inc. (Nasdaq: RICK) and VCG Holding Corporation (Nasdaq: VCGH) are the largest. In fact, RICK was in talks to purchase VCGH. Perhaps, these stocks don’t get much attention because, unlike smoking and drinking, patronizing a strip club is not something most people talk about openly. Let’s be honest, most of us have attended a bachelor party (or three), wouldn’t you feel better knowing that the money being spent was helping your bottom line?

While followed by a few analysts, they do not work at the bulge bracket firms. Thus, they are not widely followed by the investing public. Add the fact that the industry enjoys significant barriers to entry and we have the makings of potential diamond in the rough. Once you look beyond the shiny pole, music made for gyrating and names only found in fiction books you will find a cash printing press. While not every club is a winner, with the right formula, investor gains could be right on the center stage.

This piece focuses on Rick’s Cabaret, the “category killer.” RICK, with a market cap of $84 million, was founded in 1983 and went public in 1995. The company owns and/or operates approximately 20 adult nightclubs primarily in Texas. The company also has locations in Las Vegas, Minneapolis, New York (Playboy named Rick’s #1 in the city), Charlotte and Philadelphia. RICK states that it is filling “a void the market for a first-class adult nightclub.” The company targets more affluent customers by employing experienced entertainers (no first time dancers there), maintaining a first-class bar and restaurant operation (go ahead, try the lunch buffet) and creating an atmosphere of an upscale restaurant with music at levels at which “conversations can take place” (better for hearing your invitation to the champagne lounge). On top of all that, they offer memberships for VIP rooms which provides an even higher level of “service and luxury.”

Other businesses RICK operates include websites which feature adult content and a dating site that caters to the swinging lifestyle. In addition, the company owns an adult auction sites – think eBay for your naughty DVDs, apparel and paraphernalia. Finally, the company owns a trade magazine along with two industry trade shows, two other industry trade publications and more than 25 industry websites. Combined, these activities amount to less than 15% of the company’s revenue and less than 1% of operating income.

So just how does an operator of adult clubs make money? As Jaime Foxx and T-Paine say, blame it on the alcohol. Beverage sales accounted for 39.9% of revenues in 2010 (year end is September 30). To wit, the company compares its stock price performance in its Form 10K to, among others, Buffalo Wild Wings – the restaurant operator. “Service Revenues” made up 45.5% of revenues. If you are like me, you’re wondering exactly what “Service Revenues” encompass. Reviewing the company’s filings you won’t find anything definitive. RICK employs 1,200 people, of which, 120 (or 10%) are in management positions. In addition, the company has independent contractor relationships with approximately 3,000 entertainers. These people are self-employed and conduct business at the company’s locations on a non-exclusive basis. As independent contractors, the entertainers pay the club a fee for providing facilities to ply their craft.

RICK is a roll-up growth story. In the past three years, the company has acquired 9 clubs. The roll-up strategy should provide the economies of scale with regard to its purchase activities. The down side to the strategy is the capital expenditure required to renovate the clubs in order to meet the company’s quality standards. In conjunction with the acquisitions, RICK gives put options for the stock that it issues to certain sellers. These puts allow the seller to have the company repurchase shares it was issued (this would be done if RICK shares performed poorly). The maximum liability related to these put options (if RICK stock were zero) stands at $7.8 million as of September 30. This, however, would have no income statement affect. Given the acquisitive nature of the company, it is important to look at per share growth. While revenues have grown at a compound average rate of 36% over the past 5 years, revenue per share has grown at a more modest 15%.

RICK Selected Financial Data

Looking at the balance sheet, there are a few issues that need monitoring. The company has $62.1 million of goodwill and intangibles. Despite being marked down $20.5 million in 2010, goodwill remains high as a result of the acquisition strategy. To put this in perspective, total stockholders’ equity was $73.3 million, meaning that tangible equity is only $11.2 million. This was probably a “kitchen sink” type charge, it is unlikely the company will incur another charge in the near future. Nonetheless, book value per share has grown at compound average rate of 26% – despite the impairment charge. On the liability side of the balance sheet, the company carries a large debt burden. The debt to equity ratio stands at 61% with $7.9 million coming due in fiscal year 2011. The real issue, however, is 2013 when $13.5 million comes due. The company has been active issuer, if the markets remain liquid, debt maturities should be less of a problem. On the positive side, the company had $19.2 million (or $1.91 per share) of cash and equivalents at year end.

There is plenty to like about the RICK story – beyond the 3,000 scantily clad entertainers. First, management owns 15.7% of the company’s stock. Secondly, the level of disclosure the company provides with regard to the each of the segments and their profitability is commendable. Then there is significant barrier to entry – federal regulations limit the amount of land set aside for adult entertainment. Compared to its “peers” leverage is low. While interest coverage has dropped from a high of 6.1x to 3.9x, interest costs appear manageable. With the upcoming Superbowl in Dallas and the Final Four in Houston, RICK is likely to see an increase in activity. While RICK will likely traded at a discount to the market given the “taint” of being a “Sin Stock” it could close the gap. If the company can boost its margins by 2%, which would still be 10% below levels achieved in 2008, RICK shareholders could see an eye popping return of over 30% from current levels.

RICK Trading Comps

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