RICK - RCI Hospitality: A Comprehensive Analysis Of A Fast-Growing Serial Acquirer

2023-03-31 07:29:28 ET

Summary

• RCI Hospitality is a fast-growing, serial acquiring company with a smart capital allocation strategy.
• The return on tangible capital for RICK points to a deep moat that, if sustained, could produce outstanding results for investors over the long term.
• However, there are risks to consider, such as the impact of acquisitions on free cash flow, and the company's exposure to commercial real estate.

Introduction

Sin stocks refer to shares of companies involved in activities that are generally considered unethical or immoral, such as tobacco, gambling, adult entertainment, alcohol, or weapons. These types of investments are often excluded by some investors due to the perceived moral implications of profiting from human vices.

In my personal view, the institutionalization of the nightclub industry can bring many benefits to employees, customers, and owners. Small, privately-owned strip clubs may have a higher likelihood of engaging in shady practices, whereas public companies are subject to greater scrutiny and are more likely to operate within the boundaries of the law. Therefore, I believe that investing in a publicly traded company like RICK can be a responsible and ethical decision.

RICK's Growth & RICK's 'magic':

From fiscal year 2017 to 2022, RCI Hospitality Holdings, Inc. (RICK) was able to achieve a remarkable compound annual growth rate of 42.0% in diluted earnings per share, which was largely attributed to a 13.1% CAGR increase in revenue and a 41.0% CAGR increase in net income. Furthermore, net cash provided by operating activities and free cash flow also showed significant improvements at 25.1% and 25.0% CAGR, respectively, over the same period.

One of the key drivers of this exceptional growth is RICK's strategy of acquiring nightclubs that produce strong cash flows at 3X to 5X EBITDA. Since RICK has an EV/EBITDA multiple in excess of 10, all of these acquisitions are immediately accretive to their balance sheet. This roll-up strategy has been consistently delivering value to shareholders since its implementation.

Moreover, institutionalization of nightclubs brings economies of scale and operational efficiencies, which can further boost the profitability of new acquisitions.

Capital Allocation Strategy:

RICK follows a disciplined capital allocation strategy to guide the use of its free cash flows, but may deviate from it in case of other strategic considerations. Free cash flow is calculated as net cash flows from operating activities minus maintenance capital expenditures. The management believes that the after-tax yield of buying RICK's own stock serves as a benchmark for making better investment decisions.

Based on RICK's current capital allocation strategy, the company will consider acquiring or developing its own clubs or restaurants that can potentially provide a minimum cash on cash return of 25%-33%, absent any strategic rationale. RICK will also consider disposing of underperforming units to free up capital for more productive use, buying back its own stock if the after-tax yield on free cash flow is above 10%, and paying down its most expensive debt if it makes sense on a tax-adjusted basis or for strategic reasons.

Valuation:

RICK places great emphasis on its free cash flow yield and growth rates, but when accounting for acquisitions, the free cash flow rates are less impressive. The acquisition of clubs often leads to a significant amount of goodwill and intangibles, which make up around 40% of their total assets. Those who seek investments backed by a low price-to-tangible book value may not find RICK appealing. Additionally, some intangibles require write-downs after purchase, which do not affect cash flow but impact earnings. As a serial acquirer planning to spend $200 million annually for the next three years, RICK's non-cash costs may be recurring. Since implementing the new capital allocation strategy in 2016, growth has accelerated, and valuation multiples have expanded. While revenue and cash flow from operations have averaged growth rates in the mid-teens, the EV/EBITDA of 11X appears attractive. However, since most growth is through expansion and accompanying debt expansion, the risk of making M&A mistakes must be considered. I try to estimate RICK's enterprise value in 2033 by utilizing a growth rate 50% lower than the one we have experienced in the previous 5 years. If we use the average multiple of the past decade, the stock price in 2033 could be $146, representing a double in a decade. Adding the free cash flow to equity holders during that time, the return would be around 11% CAGR. While acceptable, it is in line with the S&P 500's average, and given the elevated and idiosyncratic risks, a higher return is desirable. An optimistic scenario of 12% earnings and cash flow growth over the next ten years could yield returns exceeding 16% CAGR or a 4.5x return on investment. This would be an acceptable and required return considering the risks involved.

Risks:

The fact that the company is a serial acquirer may increase the risk of making M&A mistakes, which can lead to a higher stock price crash risk (Study on empirical serial acquirer results: Serial acquirers and stock price crash risk: International evidence ). Additionally, the company's use of director relative suppliers and loans from former board members at above average interest rates could raise questions about the company's governance and management practices. The limited use of the company jet for private purposes and the SEC settlements related to this use may also be a cause for concern ( 10-K ).

Furthermore, the company owns real estate assets that may be at risk of losing value in the near future. It is important to consider these risks before investing in RICK and to conduct further research to determine whether the potential returns outweigh the risks.

ROIC net of Intangibles:

I emphasize the importance of ROIC (return on invested capital) net of intangibles. Intangibles are assets such as goodwill and brand recognition that do not have a physical presence and do not require the same level of maintenance capex as tangible assets. RICK has a low amount of tangible equity (only $30 million) but is producing $55 million in net operating profits, which equates to a 20% ROIC and over 100% return on tangible equity. These numbers are seen as a hint at a deep moat, meaning that RICK may have a sustainable competitive advantage in the market. If RICK can maintain these kinds of numbers once the serial acquisitions phase stops, then it would obtain outstanding results.

Conclusion:

In summary, RCI Hospitality Holdings Inc. is a fast-growing, serial acquiring company in the strip club and hospitality industry. The company has been expanding rapidly through a smart capital allocation strategy and has obtained outstanding results in recent years. However, there are some risks associated with this growth strategy, including potential M&A mistakes, high stock price crash risk, and risks related to the commercial real estate market. In addition, there are some concerns about the company's dealings with director-relative suppliers, loans received from former board members at above-average interest rates, and the use of a company jet for limited private use. Despite these risks, the company's return on tangible capital points towards a deep moat that, if sustained, could produce outstanding results for investors over the long term. Overall, while there are risks to consider, RICK could be a promising investment opportunity for those willing to accept the potential risks and uncertainties.

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