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%.