RCI Hospitality: short-term weakness, medium-term opportunity (NASDAQ: RICK)

RCI Hôtellerie Holdings (NASDAQ:GRINDSTONE), the operator of a nightclub and restaurant, reported that the company Second quarter results following my previous article on the stock, and I shared other recent company developments related to club and restaurant expansion. Growth has arrived at a low level, especially as Bombshells continues to underperform, but RCI Hospitality’s medium-term growth prospects remain solid with aggressive development of new locations.

I have already published an article on the company called “RCI Hospitality: an opportunistic capital allocation strategy“. In the article published on 5^th of March 2024, I reviewed the company’s opportunistic capital allocation strategy and its successful long-term implementation. Due to the low short-term upside potential in the valuation at the time, I initiated the stock with a Hold rating. Since the publication of the article, RCI Hospitality shares have lost -21% of their value. During the same period, the S&P 500 posted a positive return 7%.

Short-term revenue outlook has weakened

Before announcing the second quarter financial results on the 9th^th of the month of May, RCI Hospitality published quarter sales and other company developments on the 9th^th April after the market closes. Club and restaurant sales were $71.7 million, compared to revenue estimates of $74.5 million. The stock reacted with -7% the next day. Final revenues amounted to $72.3 million on the 9th^th of May, with nightclubs reporting $0.4 million in revenue higher than reported in the initial update, and with $0.1 million in other sales, however.

Final revenues show year-over-year growth of 1.1%, compared to 5.6% in the first quarter – sales growth appears to be slowing with weak same-store sales seen in the second quarter. No specific reason was given for the underperformance in same-store sales, but I believe the decline is at least partly attributable to a turbulent macroeconomic environment.

RCI Hospitality continues to open new locations and continues to acquire new locations, thus offsetting weak same-store sales – revenue increased in the 2nd quarter despite weak same-store sales and the press release press of 9^th of April shares the development of a large number of new locations planned – four new nightclubs opened in March-April or received building permits or a liquor license, two nightclubs are being converted and a letter of intent for the acquisition of a nightclub was signed. Three new Bombshells locations are expected to open in late summer.

I expect the slow growth to continue over the next two quarters, especially as the two casinos built are still awaiting their gaming licenses. Nonetheless, revenue should ultimately rebound aggressively thanks to expansion fast, and the long-term growth scenario remains.

Bombs Segment Shows Continued Weakness, But Has Launched Significant Improvement Initiatives

Revenue at restaurant chain Bombshells performed incredibly poorly – despite an increase in total restaurants by 11 in the first quarter/fiscal year 2022 in 14 to the end of the second quarter/fiscal year 2024, total revenues fell with incredibly high declines in same-store sales. Same-store sales in the second quarter were 20.5% lower than in the second quarter of fiscal 2023, showing an absurdly large decline that macroeconomic pressures alone cannot explain. Sequentially stable sales still show some relative strength in light of historical declines, but a quarter of Bombshells sales stability cannot be extrapolated as past performance shows.

RCI Hospitality has launched cost-cutting initiatives in the segment, as well as management changes and marketing evolution. Implementation of the initiatives began in mid-February and significant results have not yet been observed in the second quarter due to timing. Segment operating profit was $0.7 million in the second quarter, compared to $1.8 million in the second quarter/fiscal year 2023 – in a few quarters, we expect performance improvements to be seen at as improvements are implemented, but I’m not suggesting you get your hopes up. yet another significant turnaround.

The change in strategy around profitability seems to have been achieved with a very late reaction. Bombshells has continued to decline in same-store sales, and RCI Hospitality continues to open new locations for the chain with three new Bombshells locations expected to open in late summer 2024, with the concept currently still clearly underperforming. In the Second Quarter Earnings Calla goal of bringing Bombshells back to $60 million in annual sales with a 15% operating margin was mentioned, but I take that goal with a lot of skepticism until better performance is shown.

Last February, RCI Hospitality focused largely on the weakness of Bombshells in the First Quarter Earnings Calland proposed the possibility of potentially selling the underperforming segment.

The valuation becomes more attractive

I have updated my discounted cash flow (DCF) model estimates to account for slightly lower revenues than previously in the near term. I now estimate growth of 0.8% for fiscal 2024, up from 6%. Next, I estimate slower growth of 9% for FY 2025 but accelerated growth of 12% for FY 2026. Starting in FY 2027, I estimate the same revenue growth as before, the revenue of $579.9 million in fiscal 2033, up from $609.9 million previously.

Due to weakness in Bombshells and slightly weaker than expected nightclub same-store sales, I lowered the final EBIT margin estimate from 21% to 20.5% and made an adjustment to the largest decline in fiscal years 2024 and 2025.

With slower absolute revenue growth, I estimate that cash flow conversion will be somewhat better than previously in the coming years, especially since many heavy investments have already been made up front.

Estimates place RCI Hospitality’s fair value at $58.92, 35% above the stock price at the time of writing. The share price trajectory has reflected lower short-term earnings, but now represents a more attractive long-term entry point, as the long-term investment case remains quite similar. The fair value estimate is down from $61.69 previously.

A weighted average cost of capital of 9.56% is used in the DCF model. The WACC used is derived from a capital asset valuation model:

In the second quarter, RCI Hospitality recorded interest expense of $4.0 million, bringing the company’s interest rate to 6.90% with the current amount of interest-bearing debt. I kept the long-term debt ratio estimate the same, at 40%.

To estimate the cost of equity, I use the US 10-year bond yield of 4.22% like the risk-free rate. The 4.60% equity risk premium is that of Professor Aswath Damodaran latest estimate for the United States, updated on 5^th of January. I kept the beta estimate, ESG addon, and liquidity premium the same at 1.13, 1.5%, and 0.4% respectively, creating a cost of equity of 11.32% and a WACC of 9.56%. The WACC remained almost the same as 9.62% previously.

Take away

Recent developments at RCI Hospitality have pushed near-term growth prospects lower as the second quarter showed poor same-store sales and the two developed casinos continue to wait for their gaming licenses. Bombshells also continued to perform incredibly poorly, with flat sequential revenue in the second quarter being too short a period to extrapolate stability.

Yet the case for investment is now more compelling than before. RCI Hospitality’s aggressive expansion continues with many new locations expected to increase revenue soon, and initiatives have been taken starting in mid-February to improve the underperforming segment. Bombshells’ improvements should be viewed with skepticism at the moment, but the company’s overall growth prospects still look incredibly good in the medium term. With a lower valuation than before, the current share price reflects a more attractive entry point: I am upgrading RCI Hospitality to a Buy rating.