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A Small-Cap 'Sin Stock' With 125% Upside

By: StreetAuthority
Posted: 10/11/2013 2:00:00 PM
Referenced Stocks: PM

"Sin stocks" are popular because they benefit from extremely loyal customers. But the problem for growth investors is that most of these companies are fairly mature and well past their years of producing big capital gains.

Phillip Morris ( PM ) is a good example. Although PM pays a solid 4.3% dividend yield, it's returned only 27% in the past two years, underperforming the S&P 500 Index's 38% return. Strong customer loyalty drives a nice stream of income, but in this case, it leaves something to be desired in the growth department.

That's why I am intrigued by a rare small cap in the sin stock field. Not only does this company benefit from extremely loyal customers, it also offers big upside. That has led to a 37% gain in 2013 after a recent 30% jump. Take a look at the big gain below.

But while investing in sin stocks isn't for everyone, they can also be quite lucrative, and today I'm going to tell you about one that definitely fits the bill.

Rick's Cabaret International (Nasdaq: RICK) owns and operates more than 50 high-end nightclubs that cater to business professionals in the U.S. Rick's gets most of its revenue from its core nightclub business, but the company also offers some revenue diversification with a growing presence in the restaurant business, industry trade publications, trade shows and more than 25 websites.

As you can see from the chart, Rick's is having a great year. Even better, the company is still at the front end of a long-term growth cycle -- and that's a big opportunity for early investors.

As it stands, Rick's is valued at $110 million and owns just over 50 high-end nightclubs. But management recently said it thinks it can eventually increase that nightclub count nearly tenfold, to 500. That might sound like wishful thinking from an overly optimistic management team loaded up with options. But here's the upshot: This is an industry that is ripe for consolidation.

Think of it as the corporatization of the high-end nightclub industry. Rick's is able to purchase existing clubs and implement more efficient systems and operational standards to increase revenue while also expanding margins. That is a highly scalable business model -- and it's the key to the Rick's growth story.

Speaking of the business model, there are two factors that make Rick's unique.

The first is that it gets 40% of its revenue from alcohol sales. Not only does that provide huge margins after big markups, it's also an important source of revenue diversification and stability as alcohol consumption is almost immune to recessions. Rick's is also unique because it requires its performers to pay fees to perform at its clubs. It's a smaller revenue line -- but it's also another strategy for Rick's to drive sales and offset operating costs.

Rick's is taking a strategic approach to location expansion as well, focusing on high-growth and urban markets in states with low levels of unemployment. That has made Texas one of its favorite targets. In just the past two weeks, Rick's announced a 49% stake in a gentleman's club in Dallas and a deal to buy a property in Beaumont for a new restaurant and sports bar.

That's another key aspect of the Rick's expansion strategy. Unlike many restaurants or retailers that rent or lease their facilities, Rick's owns 90% of the real estate assets that house its restaurants and clubs. This is important to Rick's business because alcohol licenses are granted on location and usually cannot be moved. That lets Rick's control its own fate with locations and lease rates. It also creates another powerful source of income and a solid tax write-off.

Risks to Consider: Owning its real estate assets has weighed on Rick's balance sheet, with $75 million in long-term debt. Although earnings and cash flow remain strong, a leveraged balance sheet can create liquidity problems in an economic contraction.

Action to Take --> Rick's is a rare sin stock that benefits from customer loyalty while also offering big upside. Analysts are calling for earnings of $1.37 in 2013, a 43% increase from last year. But in spite of that bullish projection and an outsize gain on the year, this growth stock looks undervalued. If shares traded with the same forward price-to-earnings (P/E) ratio of 18 times as its peers, Rick's would jump to $27, a 125% increase from current levels.