RCI Holdings ( Nasdaq - RICK ) -- Takes Off

RCI Holdings (RICK $11.00) operates a network of 41 adult nightclubs.  The largest concentration is in Texas.  But the company has locations a number of cities from coast to coast.  Good looking women are the prime attraction.  RCI generates income in a variety of ways.  Liquor is the most profitable.  The girls who work at the clubs are independent contractors who typically pay the club for the chance to perform there.  Their income is provided by tips, which customarily are high.  RCI manages a broad spectrum of properties.  High end clubs in New York City and Miami are especially profitable.  Successful clubs also are owned in oil producing areas.  Those have benefited from the industry's expansion over the past several years.  RCI aims at less affluent customers, too.  That segment of the market nosedived with the 2007-2008 recession and still hasn't recovered completely.  Adult entertainment is a discretionary item.  Income disparity is a significant factor affecting demand.

RCI has reorganized its nightclub base to follow the changes in consumer spending.  Store level operations have been modified, as well.  Major investments were made in upscale markets to attract high income patrons.  Those have proved highly productive.  RCI also has moved away from the discounts it used to maintain traffic in the recession's aftermath.  That effort bolstered profit margins at some clubs but had negative impacts in lower income areas.  Under-performing locations now are being sold off, which should enable overall margins to improve further.

RCI recently branched out into the conventional restaurant business.  The company has launched four "Bombshells" to date.  Two more are under construction.  That segment is profitable at the store level with average annual sales approaching $4 million per unit.  Start-up costs are holding back reported earnings.  The new line promises to diversify risk while opening up a promising growth opportunity.  A move into franchising could provide further leverage down the road.

RCI owns the real estate where all its adult nightclubs operate.  Licenses to operate almost always specify a single location.  The company can't risk losing its lease, because it would have nowhere to relocate.  Debt is high ($69.3 million), as a result.  Fixed assets, mostly real estate, are carried on the books at $112.7 million.  Market value is believed to be higher.  RCI plans to simplify its capital structure by spinning off the real estate and related debt into a REIT, which the company itself will manage.  Shares in the REIT ("real estate investment trust") will be sold to investors in a private offering.  The company hopes to net approximately $50 million in cash ($4.50 a share), while extinguishing its mortgage liabilities.  Future earnings will be reduced by lease payments to the REIT.  But those are expected to be similar to the company's current mortgage interest outlays.  Earnings are unlikely to be reduced materially.  And RCI will have $50 million in extra funds to work with.

Meantime, margins and same store sales are improving.  Jettisoning the under-performing units plus the move into upscale markets helped same store revenue increase 6.9% in the September quarter.  Earnings have not been reported yet.  But they likely showed solid gains, as well.  We estimate earnings advanced 16% to $1.25 a share for the fiscal year (September).  Bombshells start-up costs and discontinued operations probably offset margin improvement in other areas.  Next year a 28% improvement to $1.60 a share appears achievable.  A stock repurchase program could provide additional leverage.  Our estimates don't reflect any use of the REIT proceeds.  The company has not indicated how it plans to deploy those funds but acquisitions, dividends, and higher buybacks are possibilities.

In 2-3 years earnings could achieve $2.35-$2.95 a share.  Applying a P/E multiple of 15x to the midpoint of the range suggests a target price of $40 a share, potential appreciation of 260% from the current price.

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