RCI Hospitality: Defining Iconoclastic
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Google defines iconoclastic as “characterized by attack on cherished beliefs or institutions.” In public markets it can be defined as RCI Hospitality (RCI). RCI is one of the most truly unique stories I have come across in my investing journey to date. Hit with SEC fines, auditor issues, and simply being a company built around in-person entertainment during a pandemic, RCI is up nearly 12x from its COVID low and yet still presents an excellent opportunity for investors. Led by founder and CEO Eric Langan, who himself is the personification of iconoclastic, RCI’s primary business is a roll-up strategy of gentlemen’s clubs throughout the United States. In addition to the roll-up, the company has recently started to roll out its Bombshells restaurant concept, think Hooters with a military twist. Inherently iconoclastic in nature, the company becomes an immediate pass for many potential investors, resulting in the rare opportunity to buy an exceptional business at an exceptional valuation.
Before going into the gentlemen’s club business itself, a good place to start is the roll-up part of the business model. By now, I am sure plenty of readers are aware of the private equity roll-up strategy. For those that need a refresher, it typically sounds something like the following: buy up a bunch of small businesses at low multiples from retiring Baby Boomers who have no natural buyers and whose kids don’t want to take over the business. I have seen this playbook becoming increasingly more popular over the last year or so (and for what it’s worth have also been in running it), but am yet to see a model that is as defensible as RCI’s. Besides the positive dynamics that come with the actual gentlemen’s club business, which we’ll discuss next, the reason for this is that it simply isn’t a business that most people want to be involved in. The negative perception around the gentlemen’s club industry has scared away nearly all buyers, from family heirs to private equity, and everyone in between. From this starting point the question becomes, “So what exactly does RCI’s potential M&A runway look like?” There are approximately 2200 gentlemen’s clubs in the United States. RCI’s strategy revolves around buying prime clubs in prime cities. According to management, this criteria leaves about 440 potential acquisition targets. With a current base of 56 clubs, RCI has a long runway for growth.
I had to do a double take when I read that the Nightclubs segment (the reporting segment of the gentlemen’s clubs) has gross margins around 90%, and operating margins that typically sit in the 30-40% range (this large variation comes from the timing of integrating new clubs). The reason for this is that the clubs come with an inherent regulatory moat. New clubs are almost never built as regulators are extremely hesitant to give out licenses, and even more hesitant to give out accompanying liquor licenses, due to a rampant case of NIMBY-ism (Not in my backyard) amongst the American population. In turn, this creates a state of affairs that allows gentlemen’s clubs, particularly those that are considered high-quality, to set very favorable terms with their consumers due to an inescapable scarcity of supply (think sporting venues or airports). A couple of examples of this dynamic that contribute to the high margins are the requirements of cash, of which the clubs supply the ATMs, and a minimum drink requirement upon admittance.
The last key dynamic to understand about the gentlemen’s club business is that it is surprisingly resilient. This resilience comes in two forms. The first is the longevity of the clubs. Typically, the nightclub industry is run on fads, promotions, and special events, leading to businesses whose quality is highly questionable. The niche of gentlemen’s clubs benefits from the exact opposite dynamic. Clubs that reach the pinnacle in a given area often stay that way for decades. The second place resilience comes to the forefront of the business is during economic downturns. While of course the business was hurt during the pandemic, as (to most) gentlemen’s clubs are hard to justify as an essential business, the industry tends to fare well in recessions that do not result in people being locked in their homes. Another statistic that almost made me do a double take was that at its low point during the Great Financial Crisis, RCI’s comps went down less than 5% (!!!). As a completely discretionary business, this figure is exceptional, to say the least, and should give investors comfort in the strength of the business during an economic downturn.
Other Items of Note
While most clubs are simply traditional gentlemen’s clubs, a small but increasing number of clubs have other attractions as well. One of these is gambling. RCI currently offers gambling options in a few existing locations and is building a new location in Colorado that will have a gentlemen’s club, casino, and steakhouse rolled into one.
Though it technically falls into the “Other” business segment and is insignificant in terms of revenue, it is worth highlighting RCI’s media business. The media business is the largest in the world dedicated to the gentlemen’s club industry. It operates websites, magazines, and in-person events, which, despite their insignificant revenue contributions, serve as an advertising tool for RCI and the industry as a whole.
As mentioned before, Bombshells is a restaurant concept similar to Hooters but with a military-themed twist. The business offers very strong returns on investment, with a typical payback period of less than two years. That said, this largely comes from what the company describes as a “honeymoon period” within the first six months of opening. After that, the restaurants have seen declining performance. Though the restaurants have been in decline, they are still cash flow positive - a major plus as management attempts to turn them around. All of that said, the big positive with Bombshells is the two multi-franchise deals the company currently has in place. These deals will allow for an asset-light approach to scaling the concept while providing cash that will fall straight to the bottom line through royalties, which come at no cost.
(Potential) Points of Concern
As we discussed at the start, this company does come with a couple of potential sticking points for some investors. The first being the SEC situation. The TLDR version of this is that a couple of the company’s executives had used company funds for things, such as private jet charters, that were improperly accounted for. It’s not that these “expenses” were hidden, as they were all reported, but rather they were reported the wrong way. This led to a slew of SEC fines, which were settled in 2020. The company has had no similar issues since.
The second of these sticking points is the change in auditor in 2019, just two years after appointing its prior auditor. This is often cited as a red flag, especially when coupled with an SEC investigation. While normally I would be hesitant to side with the company in a situation like this, it seems quite clear that RCI was not high on the priority list of this auditing firm, to put it nicely, resulting in late audits that caused delayed SEC filings. I believe this more than justifies a change.
The third point is what makes most people love or hate the company - it is iconoclastic in every way. Some say management lacks focus by adding seemingly random business lines, like Bombshells or its failed line of energy drinks, and has been described as “unprofessional” for running its conference calls on Twitter - just a couple of ways in which the company redefines being iconoclastic for a public company. While to most investors or potential investors these are red flags, I actually view them as positives. Right or wrong, founder and CEO Eric Langan is unapologetically himself. He didn’t go to a prestigious business school, but rather the school of hard knocks. While he does make mistakes, what you see is what you get. He is seemingly very open and honest, plus he lives and breathes RCI.
Because of the many factors that come into play when assessing RCI, it is hard to put an exact value on (though I tend not to anyway), but what is quite clear is that it’s undervalued. Even though management tends to under-promise and over-deliver, which we’ll touch in a second, we’ll use the low end of its free cash flow guidance of $68M, as a reference point. Using this figure, RCI is trading at a 10.5x EV/FCF multiple. This is not particularly demanding for a company of this quality, but it gets really interesting once we factor in growth. To start, we’ll just focus on the clubs part of the business as it represents about 90% of operating income. On the surface, management says they expect growth to be in the mid-teens, but they tend to under-promise and over-deliver. When pushed, Eric will admit that 25% is probably more realistic, and he prefers to surprise to the upside. Bringing it all together, a 20%+ growth rate, coupled with a 10.5x EV/FCF multiple, and an extremely defensible business model should yield very good results for shareholders. On top of this, you are getting Bombshells as a free call option.
Though not for everyone, RCI presents a great opportunity for investors. It is far from a perfectly clean story and certainly has some things you may need to get comfortable with, but that is often the reason why opportunities like this present themselves. Despite the possible concerns, being able to buy a genuinely high-quality company with a long runway for growth at a double-digit free cash flow yield is a truly rare opportunity.