RCI Hospitality Holdings Inc. is also transforming itself to appeal to mainstream investors.
Fans of ESPN’s acclaimed documentary series, “30 for 30”, will recognize the title of this article as the tagline for the series. The series’ most recent documentary, “Nature Boy”, featured Richard Fliehr. Fliehr was a little-known grappler until he changed his name to Ric Flair and took on the persona of the Nature Boy, in the process becoming arguably the greatest wrestler of all time.
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What if I told you a company, coincidentally formerly known as Rick’s, with the unique ability to be the consolidator in a fragmented industry, has over 50% upside as it transforms itself to appeal to mainstream investors?
“Space Mountain may be the oldest ride in the park, but it has the longest line.”
In the mind of some, RCI Hospitality Holdings, Inc. (RICK), formerly Rick’s Cabaret, may be involved in the oldest profession. However, in reality, RCI is a leading hospitality company and best-in-class operator in the upscale nightclub and restaurant industry. Are some of the contractors and employees at these establishments wearing less clothes than their compatriots at Dave & Busters? Sure, but as investors, do we really care?
We see the unfair stigma surrounding the industry as an amazing opportunity for RCI and its investors. In honor of Flair’s membership in the Four Horseman and his signature figure four leglock, here are the four reason we are excited about RCI:
1. The industry is fragmented and ripe for consolidation.
2. RCI has the unique ability to consolidate, given its size and the high barriers to entering the industry.
3. Similar roll-up strategies that combined good unit-level economics with depressed acquisition multiples have rewarded investors with strong returns.
4. The market has started to recognize the value of RCI’s model, though the big shops are not invested (yet).
“Diamonds are forever, and so is Ric Flair!”
While diamonds (and Ric Flair) are forever, nightclub owners are not. In fact, given when the industry started to take hold, many first-generation club owners are rapidly approaching retirement. Demographics are destiny is a platitude bandied about frequently, though for RCI it is true, and represents a powerful engine of growth.
Despite being one of the biggest players in the industry, RCI’s market share is only around 2% currently with the 38 establishments it currently owns and operates. While there are a few other larger players (Spearmint/Rhino and Déjà Vu) with some scale, most of the remaining 3,500 clubs in the U.S. are operated by individuals who typically own one or two establishments.
As these owner/operators look to exit the business, they have limited options. Banks, conservative by nature, are reluctant to make loans for such untoward establishments. This makes 100% seller financing about the only way a club’s EXISTING management team can buy the business. Sellers are exiting so they don’t have to be involved with the club, making seller financing not only sub-optimal from a lifestyle perspective but also obviously in terms of the financial risk as the underwriter of the loan.
“To be the man, you’ve got to beat the man. Woooo!”
As it relates to adult nightclubs, RCI is the man, i.e., the industry leader. In fact, there is no other institutional buyer with the reputation and financial wherewithal to acquire nightclubs in this space.
RCI’s first priority in terms of capital allocation is opening new units, either though de novo expansion or via acquisition. For most companies, if we see a line like this in a presentation regarding capital allocation, we are somewhat dubious:
We saw that seller financing is not the preferred option. Other larger operators don’t have the same access to capital markets and financing that RCI has, specifically its own currency in terms of equity and banking relationships at attractive fixed rates. This leaves private equity, which does not want to sully its reputation by investing in something so untoward, no matter how profitable. This leaves RCI as the preferred buyer. More often than not, sellers approach RCI, not the other way around.
Sellers prefer to work with RCI as it helps them better manage their cash flow and taxes. RCI typically structures deals with an upfront payout and the remainder over a negotiated period, often 8-12 years. More importantly, it minimizes the seller’s financial risk. Would you rather be owed money by the new owner/operator of a highly regulated single nightclub or a public company with a market cap of over $280 million that has been in the business for 20 years?
Ultimately, being the preferred buyer allows RCI to achieve its objective of buying properties at an EBITDA multiple typically in the 3-4x range. Given RCI’s stock has averaged 6.5x over the last five years, and is currently nearing 12x, the accretive nature of these acquisitions creates a powerful engine for earnings growth.
In terms of the magnitude going forward, RCI believes there are approximately 500 clubs that meet its stringent criteria in terms of reputation, geographic fit, size, etc. The company has the ability to integrate acquisitions easily, having just implemented a new ERP system in October 2017, and has started moving upstream in terms of size. Its most recent acquisition, Scarlett’s Cabaret in Miami, is its largest to date, and has the opportunity to move the needle in terms of earnings and free cash flow generation.
The larger the club, the more likely RCI is the only buyer with the wherewithal to make the deal happen, and the better the price RCI is able to negotiate. It does not get much better than this, and this is how RCI can continue to generate cash-on-cash returns north of 25% even while doing larger deals. In fact, each acquisition becomes more valuable as RCI’s multiple expands, so the company is poised to benefit from a virtuous cycle of larger acquisitions being even more accretive.
A transformative acquisition is not beyond the realm of possibility. Looking at the ages and circumstances of some of the industry’s biggest players, opportunities abound. In 2010, RCI agreed to acquire Denver-based VCG, though a deal was not finalized. Since then, VCG, has grown to 15 clubs. However, VCG and its founder, Troy Lowrie, have experienced issues, so it seems logical that RCI would revisit the opportunity. Jim St. John of Spearmint Rhino (formerly president of Deja Vu Consulting) has been working in the industry for over 40 years, while Harry Mohney of Deja Vu is 74, though his son remains involved.
“Whether you like it or not, learn to love it, because it’s the best thing going. Wooooo!”
RCI is one of the most intriguing earnings growth models we have seen. Being a consolidator able to buy cheaply at depressed multiples and immediately generate earnings and cash flow at these levels is the best thing going. The industry itself has attractive economics, in essence selling overpriced food and beverage around a floor of entertainment. Gross margins are high, with many of the entertainers independent contractors as opposed to employees. RCI brings institutional-caliber management and compliance to ensure clubs are run in strict compliance with local regulations. RCI often benefits from regulation, which serves as a significant barrier to entry, preventing new competition or, in the case of New York, one of RCI’s biggest markets, driving competition out of business.
We think RCI could become the next Boyd Group, another consolidator in a fragmented industry, in its case collision centers. Though Canadian in registration, Boyd operates mostly in the U.S. Its growth trajectory following a similar model is incredible, as is the steady upward climb of the stock since 2008, starting at $2.26 and heading to over $90.
Boyd trades at approximately a 16x EV/EBITDA and a 24.5x forward P/E multiple, four turns higher than RCI on EV/EBITDA and almost 10 turns higher on P/E. Using the midpoint of these two metrics yields further appreciation potential for RCI of over 50% from multiple expansion alone, much less from the sizable growth we believe is embedded in the model.
The firms have similar capital structures, though RCI has much lower returns on capital, at least at first glance. The reason: because of the nature of its business, RCI is required to own its locations from a regulatory perspective. However, as we have seen, its cash-on-cash returns are north of 25%, given the compelling nature of its business model. Most of RCI’s debt is relatively lower cost and tied to its ownership of properties, though it maintains some higher cost debt that is low-hanging fruit for refinancing, another potential boost to EPS.
Article by Opus Capital Management
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