🤝 Insiders: RICK Stock Pitch

For today’s edition we have a guest post from renowned REIT analyst, Jussi Askola.

Jussi is the CEO of Leonberg Capital, a REIT advisory firm. He writes the #1 REIT investing newsletter on Seeking Alpha, where he has over 60,000 followers. His firm provides research services to over 2,500 institutional clients.

Jussi is one of the most well-respected names in the REIT industry. He has authored award-winning academic papers on REIT investing, and been featured on numerous financial media outlets.

Overview

REITs, or real estate investment trusts, allow investors to invest in real estate properties and assets without directly owning or managing the properties themselves.

Investors love them. They provide a good source of passive investment without the responsibilities that come with property management and maintenance. And they're more liquid than physical real estate investments - they're traded on stock exchanges, so investors can easily buy and sell REIT shares.

RCI Hospitality ($RICK)

RCI Hospitality ($RICK) is a real estate investment trust (REIT) but with a twist. They follow a similar REIT playbook of scooping up real estate, jazzing it up, and then raking in cash. But instead of warehouses or hotels, RICK collects strip clubs, nightclubs, sports bars, and restaurants.

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“My biggest and best-performing investment of all time is RCI Hospitality (RICK)” – Jussi Askola

I first invested in the company during the early months of the pandemic when it traded in the $10-$20 range. I then saw the share price rise all the way to $100 per share - and I kept buying more and more shares on the way up.

The combination of earning such a large multiple and buying a lot of shares earned me a very large return.

But the interesting thing about this story is that I think that I will make a lot more from this investment in the long run and so I keep buying more of it.

RCI Hospitality: Adult Nightclub Real Estate

RICK is the only publicly listed adult nightclub company. Just like a REIT, it acquires real estate, improves it, and then operates it to earn cash flow:

Some REITs acquire industrial properties... Others acquire hotels... RICK acquires adult nightclubs... and it happens to be an extraordinarily good business because this is an inefficient and highly fragmented sector with lots of sellers, few buyers, high returns, and lots of value-add potential.

There are many sellers because lots of property owners are approaching retirement age and this is not exactly the type of asset that you want to pass as a legacy to the next generation.

There are few buyers because of the stigma of owning an adult nightclub and the difficulty of operating them.

And there is a lot of potential to add value because most owners are not sophisticated operators.

This provides RICK the opportunity to buy high-quality adult nightclubs at just 3-5x EBITDA - earning a 25-33% initial annual return on its new acquisitions.

It can typically also grow the cash flow by another 15-20% by implementing value-add programs such as rebranding, lowering costs via economies of scale, pricing strategies, etc. And it gets even better: since there are few buyers but many sellers, RICK is able to negotiate seller financing deals with very attractive terms to finance a large portion of its acquisitions, reducing its requirements for equity capital.

The resulting economics are truly exceptional.

Just compare that to a regular REIT.

REITs will commonly buy properties at a 5-7% cap rate with limited value-add potential and only earn a small spread over their cost of debt, reducing their ability to leverage the property.

In comparison, RICK is buying adult nightclubs at a >5x higher initial yield with significant value-add potential and exceptionally large spreads over its cost of capital, allowing it to structure highly lucrative seller financing deals.

This allows it to grow a lot faster. A REIT will typically grow externally by acquiring assets at a 100-200 basis point spread over its cost of capital (e.g. 6% cap rate and 4% WACC).

RICK’s does the same thing, but instead of earning 100-200 basis point spreads, it earns closer to 2,000 basis point spreads!

The proof is in the results:

RICK changed its capital allocation in 2016 and essentially became a new company. Since then, it has turned its focus to growing its FCF per share by consolidating the adult nightclub industry and the results have been extraordinary.

It has managed to grow its FCF per share by around 25% per year on average, and that's despite going through the pandemic, which was the worst possible crisis for the company!

And the market is taking notice: RICK has earned an 832% total return since early 2016 when it changed its capital allocation policy. That's nearly 10x more than the S&P500. It has even outperformed companies like Amazon (AMZN) over this time period:

Today, RICK is still fairly small with a portfolio of just ~50 clubs, it has a lot of acquisition opportunities, and it is the only buyer in this space with access to public capital.

Therefore, I think that it is well-positioned to keep executing this strategy for a long time to come. The management recently put out a plan to grow its FCF per share by 30% annually over the next three years and most of this will be achieved by acquiring new clubs.

What's the catch?

When a story sounds too good to be true, you need to ask yourself what's the catch because there is typically one.

I think that the potential catch for RICK is the long-term sustainability of adult nightclubs as a concept.

Will the concept remain desirable in the long run? Or will its clubs face a secular decline that could put RICK's cash flow at risk?

If that's the case, then it would explain why it is able to buy these assets at such low valuation multiples.

This is the main risk that sometimes keeps me up at night and so I have put a lot of work into trying to better understand this risk.

As part of these efforts, I recently flew to Southern Florida and visited some of RICK's biggest and most productive assets. I got to meet the management, ask questions, and tour the Tootsie's and Scarlett's - which are some of their biggest revenue generators.

The Tootsie's is the biggest adult nightclub in the world:

And Scarlett's is a similar large club, but it is a bit more upscale:

I came out reassured that RICK's clubs are well-positioned to thrive in the long run. Here are my 10 main takeaways from these visits and management meetings:

#1) Focus on highest-quality clubs: There are over 2,000 clubs out there, but only 500 of them fit into RICK's acquisition criteria, and they today own ~50 of the top clubs in the nation. So these are not your average "strip clubs" that are located in declining towns. These are some of the biggest and best-known clubs in some of the fastest-growing cities in the nation. The Tootsie's is even mentioned in some of Drake's songs: "I mean whoa, can’t fool the city, man, they know what’s up / second floor at Tootsie’s, getting shoulder rubs." So just because some clubs are closing does not mean that all clubs are doing poorly. On the contrary, this is a case of the weak getting weaker and the strong getting stronger because when a club closes down, it benefits the remaining high-quality clubs. It leads to less supply, less competition, and traffic consolidation.

#2) Adult nightclub vs. strip club: When I was at Tootsie's, there were a bunch of celebrities / NBA players there partying. Unlike a regular strip club that people would rather visit discreetly, this is a place where people want to be seen. RICK's management tells me that they don't even label them as strip clubs. They call them "adult nightclubs" because their properties are much closer to regular nightclubs with the addition of entertainers and shows, and they can be open late at night because they have better licenses.

#3) The license is a moat: These high-quality adult nightclubs enjoy an important moat in their licenses. Today, it is near impossible to obtain new licenses because no one wants a new strip club in their backyards, but existing licenses are grandfathered in and they are tied to the property. To give you an example: the Tootsie's is a 75,000 square feet adult nightclub that's open every day till 6 am and it is located in Miami. It would be near impossible to replicate such an asset because you couldn't get such a license these days. This greatly reduces the risks because RICK's properties enjoy a quasi-monopoly in their local markets with limited supply and high barriers to entry.

#4) Rapidly growing markets: RICK is buying clubs mainly in rapidly growing sunbelt markets like Miami and Dallas. This means that in its markets, the supply of clubs is limited by the licenses, but the demand for clubs is growing as more and more people move into these cities. The managers of Scarlett's and Tootsie's explained to me that their clubs had experienced a lot of growth in the post-pandemic world as lots of people moved down south to Miami.

#5) Late-night differentiator: Most regular nightclubs close early at around 1-2 am. This is too early for lots of people and so where do they go next? There are not many options that are open till 4, 5, or 6 am and so if you weren't feeling it at the club or if your date didn't work out, or if you are simply still craving human interactions, you might go to an adult nightclub.

#6) People want experiences: The experience economy is growing a lot faster than the broader economy. This is because increasingly many people want to spend their money on experiences over things, and adult nightclubs belong to the category of experiences. Going to an adult nightclub is something different that lots of people want to experience once in a while. Whether it is just as a "joke" or to celebrate a bachelorette party or even a divorce, people will find reasons to go to an adult nightclub to have fun. People crave human interactions and experiences and adult nightclubs give you a unique experience that you cannot get elsewhere.

#7) Getting married later: These days, people are also getting married a lot later. It is not uncommon for people to get married in their mid to late 30s and this change benefits adult nightclubs because it gives them a much longer time frame to profit from single people.

#8) Flex culture: With the rise of social media, people want to be seen and 'flex' by showcasing their life's highlights to others. This includes getting bottles at the club... throwing hundreds of single dollar bills in the air... and going to exclusive, high-quality nightclubs. You see it all the time in mainstream rap & pop culture with big-name artists/influencers hanging at adult nightclubs and so this likely isn't going anywhere any time soon.

#9) New technologies to attract customers: Historically, adult nightclubs have attracted customers by using very different strategies. They may have offered a free entry drink, had deals with taxi companies, put on some billboards, etc. But now, RICK is doubling down its digital and social media efforts to target customers and it's working well. Their clubs have their own Instagram pages... people will tag themselves there in their stories and posts... providing the clubs with free promotion. Increasingly many entertainers are also now using platforms like OnlyFans to generate additional revenue, but also lure customers into the clubs where they then have the potential to make even more money. RICK is also developing its own version of OnlyFans called 'Admireme' in an effort to maximize the synergies between digital and physical.

#10) Branding and value-add: A lot of people will be reluctant to visit a small club that has no brand value or reputation, but they will be a lot more willing to visit a large branded club such as Scarlett's because they know what to expect. RICK is able to buy clubs, convert them into their model, rebrand them, and attract revenue from a much larger pool of customers. People want something that's safe, consistent, and predictable. This is the same reason why they will visit McDonald's, despite knowing that they could probably find a better burger elsewhere. This applies particularly well to this sector because adult nightlife involves more risks and so people want to visit a club that they know is safe.

These are the 10 reasons why RICK's high-quality adult nightclubs are likely here to stay and will probably generate a lot more cash flow ten years from now than today.

Finally, I wanted to also let you hear what Eric Langan, CEO of RICK, has to say on this topic. Last year, I had an interview with him, and here are the two relevant questions and answers:

One of the risks that I think some people worry about is whether strip clubs will lose in popularity in the long run. What’s your counterargument to that?

Let’s put it this way: marriage has a higher probability of going out of style than my business. That’s because there's no upside in marriage. The beauty is there's always upside in men chasing after women. We've done it since the beginning of time. It's in our DNA. We can't change it. And until that goes out of style, all of a sudden men don't want women anymore. I don't think my business is going anywhere, as long as I package it correctly. The underlying thesis is there forever.

And I think what people are missing about technology is that we need human interaction. Humans need it. All you got to do is look at the prisons and what do they do to torture people? They put them in solitary confinement and then when they come by solitary confinement, they are the model prisoner. Why? Because they're starved for human interaction. I read these stories. I hate to use this as an example, but there are abuse victims who start developing a relationship with their abuser because it is the only human interaction they're getting. So human interaction's never going out of style. Never. They're never going to end human interaction because we need it. Our veins, our bodies physically need it to function and so the trick is to get these kids off their computers, away from their screens, or even better bring your phone to the club.

You're not supposed to record but even that's getting more normal. A lot of these younger kids, if you're 25 years old or under, your video is all over social media. Some TikTok, Instagram, Facebook, Twitter, wherever. You're already out there. They're not afraid of it. They embrace it, they welcome it. “Oh, can I tag you? Can I tag you?”

The new generation is a remarkable generation for industry. People are not realizing it because everybody keeps saying “Oh all these old men are going to quit going to your places and your customers aging out.” They say this because they have seen it happen to other adult stuff that failed to change and adapt. But what they miss is that the new generation doesn't typically get married till they're 35 years old typically, right? So that's a lot of free time for them to be single to go out and spend money and they want to flex. The difference is the old clubs used to take the big money spenders in the back rooms, right?

Private rooms, dark corners. Cause they didn't want anybody to see them. They didn't want anybody to know they were there because they were married. These young kids aren't married, they don't want to lie. They want to be up in front of the main stage. They want to throw thousands of $1 bills up in the air, making it rain, and want everybody to see them. When the bottle service comes, they want everybody to know that I've got a bottle on my table. And we just had to adapt to that. It's a nightclub now. It's more nightclub than what I consider to be an adult entertainer strip clubs. But it's super easy. It's not a different model. At the end of the day, you're just repackaging the same product, which is the entertainers, and how you package and present is all that matters. And this demographic wants their entertainment packaged in this way. So we just package it in their way and bring them in.

Obviously, you need human interactions and people will chase after women. That’s not changing. But you don’t need to go to a strip club to do that. In fact, you probably don’t want to go to a strip club to chase after women. The few times that I have ended up in a strip club have typically been after a night out. Perhaps it has been a bit boring and a friend might joke about going to a strip club and that’s how you end up there. But is that here to stay?

No, you're not chasing the women. See that's the misconception. It's like trout fishing. It's all catch and release. Nobody wants to actually catch the fish. You really catch it, but you don’t want to take it home. You don't want to eat the fish, you just want to catch the fish and let it go. The key, right?

But that's why our industry has become so late night. In the 1990s all strip clubs closed as soon as you stopped selling liquor at 2am in the morning. Today, most of our clubs close at 4, 5, 6am two or three hours after liquor sale stopped. And why? Because like just said, I don't go to strip clubs all the time, but when I do go is because I went out to a club, my date didn't work out, or the club was just not happening that night and I don't want to go home.

I'm not ready to go home. In other words, I haven't had enough human interaction. I didn't get my feel of hitting on women or women hitting on me or whatever it is.

Bottom Line

RICK is operating in fast-growing markets like Florida and Texas and has a strong moat in the licensing game.

And RICK provides investors with the opportunity to own adult nightclubs without having to deal with the operating logistics. And it turns out the adult entertainment industry is a great business for investors - it's highly-fragmented, inefficient, and has lots of sellers approaching retirement age.

The bottom line is this:

The biggest risk that I see in our investment thesis is that RICK's assets suffer a secular decline. This is not impossible, but I view this as unlikely given what I learned through my recent property tours and meetings with the management.

Of course, it depends from one club to another, but overall, RICK is buying high-quality clubs that are in growing markets with limited supply and growing demand, and there are lots of tailwinds that should keep driving strong demand for these clubs in the long run.

The nice thing here is that even if I was wrong and the organic growth eventually turns negative, I don't think that this would be the end of the world.

Most of RICK's growth comes from new property acquisitions and the management thinks that they can grow at 30% annually over the coming three years. This growth would of course slow down if its existing clubs started to post declining same-property cash flows, but the growth would still likely remain substantial.

Today, RICK is priced at just 8x its normalized forward FCF, which is a very low multiple for a company with such growth prospects.

If they manage to pull this off, they would more than double their FCF per share over the next three years. This would also likely warrant some FCF multiple expansion since it would strengthen the growth thesis, diversify the portfolio, and lower the risks.

Investors could realistically earn another 3x here in the next three years, and even if it is much less, the returns would still likely remain very compelling relative to most other stocks.

This is why RICK remains my largest investment today.

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If you’d like to read more of Jussi Askola’s articles, you can get a free trial on his Seeking Alpha.

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