Ricks Cabaret--Is Topless Entertainment Profitable?

Rick’s Cabaret International (RICK-$4.74) shares have surged 58% in the past four months, as investors anticipate that the launch of the new three-story Rick's Cabaret in New York City will be successful and accretive to earnings. Addressing a meeting of the FINANCIAL ANALYSTS AND MONEY MANAGERS, INC. (FAMMS) in New York City on October 6, 2006, Eric Langan, President and CEO, said the new club in midtown will be the Company's flagship establishment, and should generate about $8 million in revenue in fiscal 2006, which began on October 1, 2005.

Rick's primary business is gentlemen's clubs catering to businessmen and professionals. Rick's offers live adult entertainment plus restaurant and bar operations. Nightclub revenues are derived principally from the sale of liquor, beer, wine, food, merchandise, cover charges, membership fees, independent contractors' fees [dancers], commissions from vending and ATM machines, and valet parking.

The Company operates in the online adult entertainment space, too. Rick’s Cabaret owns an adult Internet membership Web site and a network of nine online auction sites for adult products. Internet revenues are derived from subscriptions, traffic/referral revenues, and commissions earned on the sale of products and services through Internet auction sites, and other activities.

Industry forecasters predict that adult entertainment –Internet, clubs, and media—is a $15 billion industry in the United States, and is poised to expand significantly over the next 10 years.

The Company’s strategy for growth rest on management’s belief that its nightclub operations can grow organically, coupled with careful entry into markets and demographic segments with high growth potential [such as Rick’s Cabaret-NYC]. This past October 2005, Mr. Langan also told the FAMMS group that Rick's Cabaret intends to participate in what he predicted will be the rapid consolidation of the adult nightclub industry over the next few years. He noted that so far in 2005 the company has acquired clubs in New York City and Charlotte, NC. The Company hopes to acquire additional clubs through a combination of cash and issuance of its common stock in a model similar to that of the casino industry during the past decade.

For the fiscal year ended September 30, 2005, the Company had consolidated total revenues of $14.8 million, an increase of $965K, or 8.97%, compared to the prior year. This increase in total revenues was primarily due to revenues from new nightclub operations. Revenues from nightclub operations for existing locations decreased by 0.74 percent year-over-year.

As for the case with the acquisition of the New York club, which does appear receptive to the Company’s upscale club formula, we remain skeptical that house traffic will show sequential growth in the summer months to come.

• The NYC purchase did not come cheap. Rick’s Cabaret paid a total of $7.625 million for the assets and stock of the erstwhile Paradise club, $2.5 million in cash and $5.125 million in a promissory note bearing simple interest at the rate of 4 percent per annum, part of which is convertible to restricted shares of common stock. In addition, the Company spent approximately $2.0 million dollars on remodeling initiatives—600K more than originally anticipated. The lease on this property is $41,469 per month, with built-in rate increase of 3.0% per annum.

Corporate paid a high price for their flagship property in New York City—leveraging existing properties that the Company owned:

• 
  Exhibit I. Club Onyx, located on Bering Drive in Houston. In December 2004, the Company paid off the old mortgage and obtained a new one with initial balance of $1,270,000 and interest rate of 10% per annum over a 10-year term. The money received from this new note was used to finance the acquisition of the New York club.
  Exhibit II. Rick's Cabaret—North Belt Drive, Houston. In November 2004, the Company obtained a mortgage using this property as collateral. The principal balance of the new mortgage is $1,042,000, with an annual interest rate of 10% over a 10-year term. The money received from this new note was used to finance the acquisition of the New York club.
  Exhibit III. XTC nightclub—San Antonio. In November 2004, the Company obtained a mortgage using this property as collateral. The principal balance of the new mortgage is $590,000, with an annual interest rate of 10% over a 10- year term. The money received from this new note was used to finance the acquisition and renovation of the New York club.

The 10Q Detective has concerns as to whether or not Rick’s has the assets in place to participate in this strategy of continued growth through acquisitions. For the FY ended September 30, 2005, the Company could not even cover all interest charges—never mind thinking about financing new clubs. Rick’s reported a loss from continuing operations of $359K and interest expenses of approximately $700K. Long-term debt increased to $13.3 million as compared to debt of $3.7 million in the prior year. The increase was primarily due to the purchase and renovation of the New York club.

Historically, the Company’s need for capital was a result of construction or acquisition of new clubs, renovation of older clubs, and investments in technology. As of September 30, 2005, Rick’s had a deficit in working capital of approximately $2.0 million. Forty-one percent of long-term debt, or $5.4 million, comes due in full by 2007.

There is an abundance of porn on the Internet, and it is popular. According to a recent study, the number of pornography related Internet pages grew from 14 million in 1998 to roughly 260 million in 2003. Adult entertainment is estimated to be the highest grossing sector on the Internet. Online pornography, a $2.5 billion business and growing rapidly, is being driven by technology. Ironically, such now-commonplace practices as streaming video, trading files and making online purchases—all were pioneered by the adult entertainment industry.

Rick’s reported that net income from its Internet businesses was $114,500 for the year ended September 30, 2005, an increase of 28.71 % from the prior year. However, Internet business revenue fell by 0.98 % to 787K. The gain in net income was directly attributable to a drop in cost of sales, 7.55% compared to 8.77% of related revenues for last year. Corporate has implemented measures to reduce expenses in its Internet operations—such as a reduction in promotional incentives for membership subscriptions.

The Company started its online adult entertainment businesses back in 1999. One has to question why—after six years—in such a high-margin, profitable segment, corporate is not too concerned that this operating segment contributes only $0.05 to every dollar in aggregate sales.

The 10Q Detective notes that Travis Reese, who became V.P.-Director of Technology in 1999, was a pilot for four years in the mid-1990s, and has an Associates Degree in Aeronautical Science from Texas State Technical College. [ed. note. (being sarcacstic) could his strong educational background in computer sciences say anything about the Company’s real dedication to its Internet business?] In 2005, Mr. Reese earned $165K in base pay. And, he just signed a new employment agreement that provides for an annual base salary of $175,000. Must be that Texas connection....

As of December 23, 2005, Directors and executive officers and their respective affiliates collectively and beneficially owned approximately 29% of Rick’s outstanding common stock. This concentration of voting control gives insiders and their respective affiliates substantial influence over all matters. For example, the 10Q Detective unearthed these juicy tidbits buried in the Company’s latest 10-KSB filing: (1) “We provide certain executive officers certain personal benefits. Since the value of such benefits does not exceed the lesser of $50,000 or 10% of annual compensation, the amounts are omitted.” [ed note. Are $20 bills for table-dancers part of these benefits?] (2) During the year ended September 30, 2004, the Company financed the purchase of a vehicle with a note payable in the amount of $31,235. [ ed. note. You would think with the monies that corporate made that they could afford to buy their own cars?]

In our opinion, contrary to managements’ claim, Rick’s upscale, adult club formula is not a proven, competitive killer application. Aside from—self-generated—media exposure, the Company has few visible earning’s drivers, and we would recommend spending your “tipping” dollars elsewhere.