Conference Call Highlights

Cautious outlook backed up by slowing trends at certain club locations, Management addresses liquidity/put options 

• Put options and debt: Rick’s used put options to pay for parts of their acquisitions last year. At the time, it seemed like a very good deal as their stock was in the $20 range, and using options as part of the purchase price for their new club locations (in addition to cash, and straight debt) was a nice way to lower the “price” of the purchase by diluting shareholders, but at a reasonable rate considering the jolt to revenue and EPS that the new acquisitions would provide.

On the conference call, the CEO, Eric Langan, stated that the 10-K (which was made available concurrently with the earnings release and conference call) contains a full disclosure of the put options and their expenses that will be currently due.

He also mentioned that they are in negotiations to extend those put options further out that would reduce their potential cash outlay in the next year.

The options have limits in terms of how many can be exercised, how many Rick’s has to purchase, etc., within a certain timeframe, which will reduce the likelihood that the stock will face further pressure of having the puts be sold and the difference reimbursed by Rick’s.

Each dollar movement in Rick’s stock price has an aggregate affect of $611,000 on the total obligation, which is about $13.9 million if Rick’s were at $0 per share.

So at $5.00 per share, the obligation is $3 million less than if it were at $0, so Rick’s is essentially on the hook for about $11 million at that level.

This is because Rick’s guaranteed that they would buy the puts from the club’s owners at predetermined prices, should Rick’s common stock fall below certain thresholds, which it has.

My Take: It is very important that investors understand how these put options work, and how they could potentialy affect Rick’s one way or another.

It seems that the market has been overreacting to the potential that Rick’s might face a liquidity crunch as a result of their obligations to pay these options at predetermined prices, but as we can see from the above calculations and Rick’s total obligation, even if their stock went to $0 per share (highly unlikely!), they would owe $13.9 million, but much less than that as their stock price is obviously higher, currently sitting at about $4.00 per share.

In addition, Rick’s only owes $2.6 million this year in debt obligations, which means that they are very well capitalized not including their usual cash flow generating capabilities.

From Rick’s 10-K:

As part of certain of our acquisition transactions, we have entered into Lock-Up/Leak-Out Agreements with the sellers pursuant to which, on or after a contractual period after the closing date, the seller shall have the right, but not the obligation, to have us purchase from seller a certain number of our shares of common stock issued in the transactions in an amount and at a rate of not more than a contractual number of the shares per month (the “Monthly Shares”) calculated at a price per share equal to a contractual value per share (“Value of the Rick’s Shares”).

At our election during any given month, we may either buy the Monthly Shares or, if we elect not to buy the Monthly Shares from the seller, then the seller shall sell the Monthly Shares in the open market. Any deficiency between the amount which the seller receives from the sale of the Monthly Shares and the value of the shares shall be paid by us within three (3) business days of the date of sale of the Monthly Shares during that particular month.

Our obligation to purchase the Monthly Shares from the Seller shall terminate and cease at such time as the seller has received a contractual amount from the sale of the Rick’s Shares and any deficiency. Under the terms of the Lock-Up/Leak-Out Agreements, the seller may not sell more than a contractual number of our shares per 30-day period, regardless of whether the seller “Puts” the shares to us or sells them in the open market or otherwise.

The maximum obligation that could be owed if our stock were valued at zero is $13,935,020 and is recorded in our balance sheet at September 30, 2008 as Temporary Equity.

We consider this type of financing transaction to be similar to interest-free debt. If we are required to buy back any of these put options, the buy-back transaction will be purely a balance sheet transaction, affecting only Temporary Equity and Stockholders’ Equity and will have no income statement effect.

Following is a schedule of the annual obligation we would have if our stock price remains in the future at the closing market price on December 5, 2008 of $4.87 per share:

For the Year Ended September 30:
2009: $2,541,538
2010: $3,527,683
2011: $2,862,975
2012: $2,023,650
Total: $10,955,846

So as we can see from Rick’s description above, they are well covered for this obligation, but where it concerns us is when those holding the shares decide to dump their shares on the open market either because they need the money, or because they feel that Rick’s share price won’t recover, in which case, Rick’s is liable for the difference between what they sold the shares for on the open market and what Rick’s promised them when the transaction was consummated.

This could explain in part why there has been such a downward drag on Rick’s share price over the last few months, aside of course from the usual stuff pertaining to the overall market declining and small and micro-cap stocks getting slammed with redemptions and hedge fund closures.

At current prices, and with Rick’s liquidity levels being where they are, and cash generation being where it is, I feel that Rick’s is sufficiently buffered from much more downside from here, regardless of what is owed and when.

Since the stock is so low already, even if Rick’s is on the hook for the full amounts listed above, they can cleanly cover those expenses.

That being said, management talked on the call about how they are trying to renegotiate with some of the option holders to extend their selling period so that they wait a longer period of time before being able to redeem their options.

• Slowing Market Trends: When Rick’s announced their October same-club sales rose an astonishing 8%, there were rumblings that perhaps Rick’s and other “sin” stocks could do well even in this downturn.

It turns out that is not the case.

On the conference all, the CEO stated that while October was strong, November turned out to be an average month, and then December is looking like a weak month, so in aggregate, the CEO is hoping for an average quarter in Q1/2009, but that they didn’t have all the data gathered yet.

The CEO commented that what they are seeing is a flight to quality; if you are #1 in a certain market, the business is increasing such as in N.Y. and Miami, and to a lesser extent Charlotte and Minnesota.

In markets where Rick’s is not the established “quality” brand, they are seeing weakness and much tougher times.

Rick’s will try to take advantage of the flight to quality by leveraging their market strengths and building their market share.

They are going to take steps in 2009 to stop losses at certain clubs such as closing underperforming clubs and/or selling them.

They are also going to save money by not making as many acquisitions in 2009 as they did in 2008.

My Take: I was waiting for some negativity in this market, and it looks like that huge consumer drop-off that we saw in late October and November has affected Rick’s just like it has every single other business out there that relies on the consumer. More color on specifics below.

• Specifically, several clubs underperforming, Vegas club results “brutal”:  The CEO stated that new clubs are underperforming from their original projections, specifically: Rick’s Cabaret in Philadelphia has been converted into a Club Onyx; the Rick’s in Dallas is also underperforming and they are looking at ways to increase revenue, as well as other locations, not the least of which is their newest and most expensive club in Las Vegas that is getting crushed.

The CEO went on to say that their biggest issue so far in fiscal 2009 has been their Las Vegas location which is not doing so well, and the CEO stated that he takes full responsibility for that.

They closed the transaction recently, and he stated that perhaps they “shouldn’t have.”

He also stated that he believed that their timing was a little off, and it was a difficult environment to predict.

When Rick’s took the club over, they were doing about $250,000 per week in sales for the first couple of weeks, but December has been much weaker than that.

He stated that they are going to have problems with their Las Vegas club and market and they are addressing it and hopefully with the convention season ramping up, this location will also pick up.

The CEO further stated later on in the call that “it’s pretty brutal in Vegas” right now.

Some clubs according to an analyst, are down 50% or more in revenue from last year, and many others are closing their doors.

When talking about Vegas specifically, the CEO then admitted that their Las Vegas club is actually down 50-70% in revenue from last year as well in what is shaping up to be one of the most detrimental and difficult discretionary spending environments in history, especially when it comes to Sin City.

In addition, the CEO stated that their Philadelphia club was converted to a Club Onyx (that caters to the upscale African American community), and they are trying to tailor their current clubs to the local environment and demand and cater to that, rather than the other way around. This location was a clear example of that.

Finally, when asked by an analyst how many and which clubs were underperforming and/or losing money (aside from Vegas), the CEO stated that there were 3 clubs: Austin, Houston and San Antonio are the major problems.

When asked to elaborate by another analyst about what they can do with these clubs, the CEO fleshed out various plans to keep costs down, renegotiate leases, and in the worst case scenario, close the locations down, and get out of the leases, or give the landlord some kind of cash buyout, and be done with the expenses.

Now for a little good news.

Rick’s N.Y., Miami, and Dallas, Fort-Worth locations continue to drive revenue and same-club sales growth and margin expansion.

In fact their N.Y. location continues to be their crown jewel and Rick’s is taking steps to keep it that way with new marketing initiatives (they purchased 2 local billboards in the N.Y. metro area), and increased attention to driving market awareness for this club.

My Take: It’s clear that Rick’s bought their Las Vegas club at the top of the market. Good for the ex-owners, bad for Rick’s.

The question will be, what are they doing about it, and how can they salvage, what usually is, a wonderful market when times are good.

In addition, it’s clear that Rick’s has a pragmatic approach to their current operations and they will not hesitate, and are in fact looking into, closing underperforming clubs or ratcheting down leases or other expenses at those clubs to bring them in line with their other locations.

Put it this way: It would be much better for Rick’s to exit 1-2 underperforming markets and have lower revenue for 2009, BUT have a much higher net income, EPS and cash flow figures because it doesn’t matter how much higher the revenue figure would be from the addition of these clubs if everything they make is heading straight out the back door.

I’m all for closing a couple of clubs, reigning in expenses, and cleaning house.

This is a perfect time for that, and with Rick’s cash flow generating capabilities, they will come out leaner and stronger on the other side, ready to indeed acquire more clubs and further expand with much better multiples as other owners look for exit strategies.

• Management’s plan for the next year: Rick’s CEO talked about their strategy for 2009 in this environment and how they would look to make it through in one piece.

Specifically, Rick’s is going to focus 2009 on: strong organic growth and to continue to build same-club sales.

The CEO stated that it is “difficult out there” and that they are getting an increase in customer counts at some clubs, but that people are spending less money and that there is indeed concern about the economy.

In addition, they are going to continue to pay down debt and build their cash position.

Finally, Rick’s acquisition strategy will remain the same in that they are looking for clubs in major metropolitan locations with high business, convention traffic and tourism.

They are looking at paying 3-5 times earnings for these clubs, and will purchase them with a mix of cash and debt, and will NOT be using stock for acquisitions because of the low value of their stock currently.

My Take: This all sounds good to me, and is the prudent course of action.

It’s obvious that Rick’s is encountering some tough times, and wasted some of their and shareholder’s money in acquiring some clubs at the very top of the market.

That’s fine, mistakes happen, and no one could have predicted what has transpired in the last year and a half, and specifically, in the last 6 months, in which the slowdown in the economy has literally obliterated many companies, both large and small.

I think Rick’s is trying to regroup, make sure they have the cash on hand to pay off their debts and other obligations, and then focus on streamlining and improving operations until things turn around.

So what’s the bottom line?…

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