RCI is NOT the Only Buyer in Town

One of the many false narratives that new investors continuously repeat is that RCI is the “only acquirer” of strip clubs, and that is why they are able to find a continuous supply of clubs at bargain prices.

“RCI is the only buyer with the wherewithal to make the deal happen”  -Investor report

“As the only publicly traded company in the industry and the only entity with significant access to bank financing, we are the acquirer of choice.” –RCI quarterly conference call

As I recommend doing with every claim made by management or the uninformed bulls, look at the facts and data, not what management tells you.

The Facts: In a single recent issue of ED Magazine alone, there were four different chains that took out advertisements to highlight their interest in clubs: Spearmint Rhino, Penthouse, Déjà vu, and RCI. Plus Scores was advertising its services to manage and turn around owners' struggling clubs. With RCI’s recent acquisitions of only $1.5 million (Kappa) and $3.2 million (Hollywood), those sellers had many potential buyers. Clearly buyers are not nearly as scarce as management and bulls claim, especially on the small and medium sized clubs.

Bulls will say but what about the mega-clubs? There are definitely fewer buyers for the mega clubs in the $20 million+ price range, but RCI is still not the only buyer, and this reduced buyer pool has yet to translate into a clear benefit for RCI shareholders.

First, it is important make it cleat that RCI is NOT the largest club operator. Management repeatedly calls itself the only publicly traded strip club operator, implying that it has a big advantage in acquisitions, and many investors mistakenly take that to mean they are the largest operator. However, Déjà vu is the largest club operator in the world, with a reported 100+ units and more than $400 million in annual revenue (vs $145 million for RCI).

Secondly, RCI is only batting 50% on mega-deals. The $20+ million Las Vegas club was an absolute disaster, but the $25 million Tootsies acquisition was a success. The latest mega-deal, Scarlett’s in Miami, was only acquired last year and it is too early to evaluate.

Mega-deals pose their own challenges, as the sellers are receiving the mega price tag for a reason. They are large, very profitable clubs with high earnings that are run by sophisticated operators. There are going to be fewer expenses to cut and operational improvements for RCI compared to a small mom and pop club. As we saw in Vegas, when a club is already optimized and earning at high levels, there is a lot of downside risk and only minimal upside. At these mega-clubs throwing off $5m+ annually in earnings, you aren’t going to find many cash-strapped desperate sellers, instead the sophisticated operators are likely to be opportunistically selling into a hot market, or foreseeing challenges in their club or region.

Here are some of the club ads from ED magazine:

Q3 PR: Another Hobby Acquisition & Club Onyx Philly Closing

 RCI Hospitality reported SSS this week. The company posted SSS growth, however it is important to remember that reported SSS growth is not the same as organic growth. Management excludes all clubs that are closed and clubs that have been reconcepted from the calculation. That means that the reported SSS will consistently overstate actual performance. The company can report positive SSS while the business is actually declining organically due to location closures.

The economy is red hot and oil prices have shot up, so it is not surprising that many of the company's clubs are seeing low single digit growth, but if you factored in unit closures and struggling clubs that were reconcepted, the actual growth would be less than the reported 5% SSS growth.

More interesting than the SSS numbers, was the news of a new purchase and a new club closure:

Peoria Club Looks Like a Hobby Purchase      

Management announced a $1.5 million purchase of the Kappa Kabanna club in Kappa, IL (Peoria MSA).  Management has repeatedly said one off purchases of small clubs in new cities do not make sense unless they are able to build a cluster of clubs that allows them to leverage shared resources, so this  small purchase was surprising.

In fact, management just recently divested its Indianapolis club for $1.8 million after only a few years of ownership because it was too small and was inefficient to manage on its own.

“Separately, Rick’s Cabaret Indianapolis was sold…..The unit performed slightly better than break even in FY16 and was too far from other units to be managed effectively.”

Indianapolis, a $1.8 million club was too small and too far away from other clubs to be managed efficiently. However, an even smaller ($1.5 million) club in Peoria is going to be efficiently managed? The new club appears to be about a three-hour drive away from the new St. Louis clubs, too far away to share employees, management, or local ad spending.

So why would RCI management waste its time on a small, relatively immaterial club in the middle of no where Illinois? All other non-Texas acquisitions have been larger clubs (or clusters) in top tier cities (NYC, Miami, Minneapolis, Charlotte, St. Louis).

I believe the answer is because Peoria is Eric’s hometown: “Langan, the son of a police officer, had spent his childhood in Peoria, Ill.” -Link 

Similar to the failed attempt to enter the California market with a small club (post here), it doesn’t seem like the small Peoria club has much strategic rationale.

Club Onyx Philly Closing

As reader’s know, one of the main points of my short thesis is that night clubs are not indefinite life assets. I backed it up with data on the post here, and I believe this week’s press release helped further prove the point as management announced that Club Onyx in Philadelphia has been closed. RCI purchased the club for more than $9 million, and tried reconcepting it before ultimately shutting it down. I will be watching closely to see how much of the investment is recouped upon sale.

The press release also stated that total night clubs in operation at the end of the quarter was 38 versus 40 in the year ago quarter (even after the inclusion of the Kappa Kabanna acquisition) meaning three clubs, or ~8% of the units, were shut down over the last twelve months in a strong economy.

RCI's Base Business is a Declining Asset

One of the biggest misconceptions among new investors that have bid up the stock is the mistaken belief that strip clubs are durable businesses with perpetuity value that deserves the current 10x EBITDA multiple (or more). These new bulls would lead you to believe that RCI acquires clubs at 3-4x EBITDA and then magically when they are added to the RCI portfolio the earnings are worth 10x+ EBITDA. The reality is that strip clubs are priced with a mid-single digit EBITDA multiple for a number of valid reasons, the most significant of which is that clubs are not perpetuity businesses.

Those following the stock closely for an extended period of time understand that every year RCI is shutting down clubs(see the impairments). A few key clubs have lasted 10-15+ years, such as the flagship Manhattan location, but many others have shorter life spans and are frequently being rebranded or closed. A large portion of clubs will eventually shut down and have their value fall to 0. RCI does not press release the closure of clubs, so it is hard to follow the closure rate and life span of their clubs unless you are actively looking for it.

RCI is essentially a leaking bathtub and should be valued as such. A club or two is being shut down every year, but RCI keeps adding more new locations every year (more water), so investors from the outside don’t realize that it is a declining business. If RCI halted all new acquisitions/developments and paid all earnings out to shareholders, earnings would decline as the natural course of business (leases expiring, brands getting stale, new competitors opening, politicians shutting down clubs, industry declines, etc.) leads to clubs shutting down over time.

If RCI pays 4x EBITDA for a club, investors and management are excited after year 1 and think they are earning a 25% ROI, however, when that club dies off and closes after year three you actually lost money and the 25% return was a mirage.

Vegas, Los Angeles, etc. were all one-year life spans before going to zero or near zero. The Texas clubs are much harder to keep track of, but you can pull acquisition press releases from 5-10 years ago and see how many of them have been reconcepted and then shut down. A few other examples from a quick search:

Platinum’s Club Acquisition (<8 year life span): RCI paid $7.5m for the club in June 2008. RCI originally reopened it as a Club Onyx, but after just 7 months in Jan 2009 it was converted to a XTC Cabaret. The club was rebranded again at least once in 2016 when it was converted to a Foxy’s, before ultimately being shut down.

Cabaret North (<5 year life span) – Acquired in Sept 2009 for $2.3m. Expected to produce EBITDA of $800k-$1M. Ultimately was shut down by 2014.

Some clubs will last 30 years, some will last 1 year, but as a whole, I do not believe the average lifespan of the clubs is more than 10 years, which makes it outrageous for investors to be willing to pay 10 years worth of earnings (or more) for an earnings stream that has an average life of 10 years or less.

RCI did not acquire any clubs in late FY 2015 or during FY 2016, and as a result, the segment’s revenue declined from 2015 to 2016. In FY 2017, the segment benefited from the opening of Hoops, plus the acquisition of Scarlett’s and Hollywood Showclub, so the segment showed growth again.

The fact that clubs are NOT indefinite life assets can also be proven without tracking individual clubs, but by looking at the consistency of RCI’s impairment charges. If clubs were indefinite life assets there wouldn’t be constant impairments. These are not one-time charges, but impairments that hit 7+ clubs over the last three years alone during a strong economy. During a recession the pace of closure and impairment is even higher.

·       2017: $7.6 million ($4.7m of goodwill impairment on 3 operating clubs and one property held for sale; $0.4m of PP&E impairment on an operating club; $1.4m in license impairments in two clubs; $1.2m impairment on  cost method investment in Robust)

·       2016: $3.5 million ($1.4m on property held for sale; $2.1m on license impairment on one club)

·       2015: $1.7 million ($1.7m impairment on license of two operating clubs)

Over 30% of RCI’s clubs are leased, so they will definitely not have perpetuity value. At the end of the lease the landlord can redevelop the land into a higher value use, significantly increase rents, lease the club to a new tenant, or force the tenant to buyout the real estate at an inflated price.

The clubs with real estate involved could collect partial return of investment upon closing, but it is likely a significant discount to the purchase price of the real estate and all payment for the operating business will have been lost. Once a club falls out of favor and a rebrand doesn’t revive it, there’s no value to other club operators. Why would they want to buy a club that has already failed twice under different brands? The real estate is also typically unattractive for non-club uses because it would require extensive renovations and due to SOB license regulations, clubs are often located in remote or industrial areas, which are less attractive to non-club buyers. As a result, you are typically dumping the real estate for a significant discount to the purchase price as you can see from the consistent real estate impairments. Book values are likely inflated from RCI overpaying, for instance the Tootsie’s real estate in Miami sold for $12.3 million in 2014 but RCI bought it in July 2015 for $15.3 million. Giving the sellers a 24% return in a year. Having been the largest tenant in the building for many years, should have pulled the trigger on the first sale in 2014 and saved the company $3 million.

Financial implications on ROI’s: The lack of perpetuity value can have a huge impact on the actual ROI of acquisitions. For example, assume you are buying a club for $100 at 5x EBITDA. If the club holds its $100 value into perpetuity you will receive the 20% return that management is quick to point out. However, if this is one of the many clubs that does not have an indefinite life, your returns will be much lower. If the club only last 4 years your IRR is negative 8% per year. If it last 8 years the IRR is ~12%.