RCI HOSPITALITY HOLDINGS, INC. annual report, FY2012

Business context and reporting period

Rick’s Cabaret International, Inc. (the filing registrant; associated with the later RCI Hospitality Holdings name) filed this Form 10-K for the fiscal year ended September 30, 2012. The filing is annual, not a standalone fourth-quarter report. The company operated adult-entertainment nightclubs and a trade-publications and events media business; it reported one segment, nightclubs. It reported 34 clubs as of December 1, 2012, following significant acquisitions during the year.

Key financial metrics

FY2012 cash flow from investing activities was a use of $11.0 million; financing activities used $11.6 million, leaving a $4.2 million decrease in cash. Total assets were $192.4 million and Rick’s permanent stockholders’ equity was $84.3 million at year-end. The filing reports an operating margin of 17.7%; however, operating income divided by reported revenue calculates to about 17.3%, so the margin figure merits verification.

For the September 2012 quarter, unaudited results were revenue of $23.9 million, continuing-operations income of $1.5 million, net income of $1.5 million, and diluted EPS of $0.15.

Material changes versus the prior comparable period

• Revenue increased 14.0% year over year, driven by 2012 acquisitions, a full year of results from 2011 acquisitions, and growth at existing clubs, particularly New York. Same-location, same-period nightclub revenue rose 4.2%.
• Despite revenue growth, operating income fell to $16.5 million from $18.8 million, and continuing-operations income declined to $8.0 million from $10.3 million. Management cited one-time litigation and legal costs; legal and professional expense rose to $5.9 million from $2.3 million, including $2.5 million of litigation and other legal settlements and $462,000 of acquisition costs.
• Adjusted EBITDA increased 7.2% to $24.4 million, a non-GAAP measure that excludes specified costs. Same-location nightclub operating income declined 1.4%; cost of goods sold for same-location operations rose to 13.2% from 12.5%.
• Debt increased 78.7%, mainly due to acquisition financing. The company acquired Silver City and the Foster/Jaguars clubs; the latter transactions added a $22 million secured club note. Acquisition-related real estate purchases also involved substantial seller and mortgage financing.
• Eleven clubs were acquired in 2012, with some closings near or after year-end. The filing’s unaudited pro forma figures including the Foster Clubs show FY2012 revenue of $109.7 million and net income of $8.7 million; these are not the reported consolidated results.

Outlook, risks, contingencies, and unusual items

• Management said the near-term outlook remained strong and expected substantial operating cash flow in 2013. It provided no specific revenue or earnings guidance. Growth plans rely on acquisitions, new openings, and financing; management cautioned that additional financing may not be available on reasonable terms.
• The Texas $5-per-visitor patron tax remained in litigation. A district court found it constitutional under the Texas Constitution in July 2012; an appeal was pending. The company had accrued approximately $9.8 million at September 30, 2012, including $3.0 million of FY2012 expense, and had not paid the tax for periods after the first quarter of 2009. The company also sought repayment of amounts previously paid under protest.
• A separate Nevada tax audit asserted approximately $2.1 million in live-entertainment taxes, penalties, and interest. The company disputed the assessment and recorded no accrual; the ultimate effect was uncertain.
• A shareholder lawsuit settled for $2.65 million, funded partly by approximately $850,000 of insurance proceeds; the company’s cash portion was approximately $1.8 million. Two text-message lawsuits settled for a combined $355,000. A wage-and-hour case remained pending, and a Las Vegas lease dispute was unaccrued because the company disputed parent-company liability.
• The company’s risks include extensive licensing and zoning regulation, competition, sensitivity to local economic conditions and consumer spending, potential entertainer worker-classification changes, acquisition integration and impairment risks, and reliance on key personnel. Management stated that annual impairment testing identified no impairment in 2012 or 2011; goodwill and indefinite-lived intangibles totaled about $94.0 million.
• The independent auditor issued unqualified opinions on the financial statements and internal control over financial reporting; management and the auditor concluded controls were effective as of September 30, 2012.

Most important facts for investors to verify

• Reconcile the filing’s stated 17.7% operating margin with operating income and revenue, which imply approximately 17.3%.
• Track the Texas patron-tax appeal, the $9.8 million accrued liability, and the possible effect of the tax on the Foster club note, which allows a principal reduction of up to $6 million if the tax is enforced.
• Assess liquidity and debt service against the $8.1 million working-capital deficit, $5.5 million cash balance, and sharply increased debt; review scheduled maturities and acquisition-related financing terms.
• Verify the resolution and any financial impact of the disputed Nevada assessment and pending wage-and-hour and lease litigation.
• Evaluate the acquired clubs’ contribution to earnings after full-period ownership, given that reported FY2012 results included only partial-period results for major acquisitions and the purchase-price allocations were preliminary.