RICK (long): 94 shares, 9.58€/Share
I recently purchased 94 shares of RCI Hospitality (RICK) and briefly want to update you why I did so. After having talked about the Greenwald Valuation for companies in my last article (before my creative time-out) I have been busy finding companies that are undervalued according to exactly these standards. At the end of this search was RCI Hospitality, a value investment gem. The company, as the title of this blogpost might hint, is active in the adult entertainment business and runs several what they call “cabarets” aka. strip clubs across America. Their business model results in the holding of a large real estate portfolio. The firm is a small cap with a market capitalization of about 80 million as of last week. Due to its size it is largely ignored by analysts. The combination of a lack of analyst-attention and what some people would call dubious industry might have created this very attractive opportunity. Currently RICK trades at a P/B of just 0.7 and a P/E of 9.0 and a free-cash-flow yield north of 15%.
Following Greenwald´s guidance to value companies I first calculate the reproduction value of assets. I won´t calculate a liquidation value since I do not see the firm going out of business anytime soon given its strong earnings. The question that arises hence is:
“What would a competitor have to pay to be able to compete with RICK”
I tried to be very conservative in my answer to that question. The figure below shows the transmission from book to reproduction values. The most important adjustment that I made was for Goodwill and PPE. Goodwill representing the value paid for the acquisition of Nightclubs above fair value was written down to zero. However, I marked up the value of land and buildings that has been sitting (largely) unchanged on the balance sheet for years by $50 MM, which is a number that the management guided for in an investor presentation. All else unchanged this results in a reproduction value of equity of about 130 million or 13 USD per share. Compared with todays share price of 8 USD this translates into a hefty margin of safety of 60%.
The main argument for the undervaluation is therefore that market participants underestimate the value of the real estate holdings of the company. Several catalysts to unlock the true value of the company are existing. For once, the management in the past started to evaluate the selling of the real estate into a REIT. However, as of late they have foregone that plan, since a REIT would not significantly lower the cost to finance the real estate due to the securing of cheap bank funding. Another catalyst is the hiring of Merriman Capital that will advise RICK when it comes to capital market interaction. The result could be the initiation of analyst coverage and therefore investor attention, which could resolve the undervaluation. Further, the management stated to not invest into new clubs and other ventures, which are usually financed by a combination of equity, cash and debt while the share price remains suppressed. All available funds after maintenance CAPEX will therefore go into share repurchases that at these levels should create significant shareholder value, by increasing the share that investors own in the valuable real estate and the cash-flow stream.
However, no investment goes without risk. RICK has a high debt burden, with 84 million of high-yielding debt outstanding. This translates into 7,3 million of interest expenses. However the coverage of 2x EBIT should be sufficient to service these payments. In recent years RICK could also successfully refinance some of their debt and thus lower its overall cost of debt down to now about 7,9% from 11.6% at the end of 2013. While this still seems high rates to pay in times of interest rates near zero in the US, there is a reason behind it. Since RICK usually buys nightclubs from private persons, who favor to shift their tax burden over several periods instead of paying all in one when they sell out for a profit. A loan to RICK mitigates that tax burden and spreads it overtime. This is also the reason why refinancing loans for RICK is not always possible.
The second risk factor is oil price. Since a lot of RICK´s strip clubs are located in oil-rich Texas, there is a risk for the business to witness slowing same-store sales on the back of lay-offs in the oil-sector. This development might largely be responsible for the slowing of sales recently. However, the Texan economy is less reliant on oil that one might think with only about 17% of economic output coming from oil. While a breakdown at the pumps will definitely hurt RICK, the broad diversification of the Texan economy will provide a floor for same store sales and help FCF to come in at about 15 million next year.
Thirdly, RICK has been on a diversification rant. The company as of late left its core competency to venture into restaurants as well as the production of energy drinks. While both undertakings seem to be off to a good start by showing early profits, the development is concerning. Funds should rather be invested into new strip clubs, since this is clearly where the expertise of the current management lies. Nevertheless, this risk factor can largely be laid to rest with the commitment of repurchasing shares by using free cash flow until the share price is well above 14 USD.
Last risk factor is the CEO Rick Langan itself. Sources claim that he is the heart of the firm by possessing the crucial expertise and relationships that are required to succeed in this industry. On the positive side the CEO is young and does not show any sings of slowing.
Despite the mentioned risk factors the company is simply to cheap to pass at current prices. And with several catalysts in place the likelihood of a higher share price in the future is high. Even if real estate is worth less than what management states, the high margin of safety would still make the investment outcome favorable. My initial purchase of RICK has been little below 10 USD. I intend to buy more shares at current prices.
long RCI Hospitality