RCI HOSPITALITY HOLDINGS, INC. 10-Q

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations. The following discussion should be read in conjunction with our unaudited condensed consolidated financial statements and related notes thereto included in this quarterly report, and the audited consolidated financial statements and related notes included in our Annual Report on Form 10-K for the year ended September 30, 2021. Overview RCI Hospitality Holdings, Inc. (“RCIHH”) is a holding company. Through our subsidiaries, we engage in a number of activities in the hospitality and related businesses. All services and management operations are conducted by subsidiaries of RCIHH, including RCI Management Services, Inc. Through our subsidiaries, as of June 30, 2022, we operated a total of 60 establishments that offer live adult entertainment and/or restaurant and bar operations, including one club that is temporarily closed. We also operated a leading business communications company serving the multi-billion-dollar adult nightclubs industry. We have two principal reportable segments: Nightclubs and Bombshells. We combine operating segments not included in Nightclubs and Bombshells into “Other.” In the context of club and restaurant/sports bar operations, the terms the “Company,” “we,” “our,” “us” and similar terms used in this report refer to subsidiaries of RCIHH. RCIHH was incorporated in the State of Texas in 1994. Our corporate offices are located in Houston, Texas. Ongoing Impact of COVID-19 Pandemic and Potential Economic Slowdown Our businesses were heavily impacted by the COVID-19 pandemic since its declaration as a national emergency in March 2020. We had a major disruption in our business operations that affected our cash flow. The pandemic resulted in a significant reduction in customer traffic in our clubs and restaurants due to changes in consumer behavior as social distancing practices, dining room closures and other restrictions were mandated or encouraged by federal, state and local governments. In 2021, our businesses started and continue to recover to date from the initial effects of the pandemic. There have been several variants to the coronavirus since then that threatened our operations throughout the period of recovery. We continue to adhere to state and local government mandates regarding the pandemic. Since early 2021, there has been a worldwide increase in inflation. In the event this global inflation leads to a major economic downturn, our business operations and cash flow could be significantly affected. Critical Accounting Policies and Estimates The preparation of the unaudited condensed consolidated financial statements requires our management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On a regular basis, we evaluate these estimates. These estimates are based on management’s historical industry experience and on various other assumptions that are believed to be reasonable under the circumstances. Actual results may differ from these estimates. For a description of the accounting policies that, in management’s opinion, involve the most significant application of judgment or involve complex estimation and which could, if different judgment or estimates were made, materially affect our reported financial position, results of operations, or cash flows, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Critical Accounting Policies and Estimates” in our Annual Report on Form 10-K for the fiscal year ended September 30, 2021 filed with the SEC on December 14, 2021. During the three and nine months ended June 30, 2022, there were no significant changes in our accounting policies and estimates other than the newly adopted accounting standards that are disclosed in Note 2 to our unaudited condensed consolidated financial statements. Results of Operations Highlights of the Company's operating results are as follows: Third Quarter 2022 • Total revenues were $70.7 million compared to $57.9 million during the comparable prior-year period, a 22.2% increase (Nightclubs revenue of $54.7 million compared to $41.0 million, a 33.3% increase; and Bombshells revenue of $15.8 million compared to $16.1 million, a 1.8% decrease) 28 Table of Contents • Consolidated same-store sales decreased by 0.1% (Nightclubs increased by 4.8% while Bombshells decreased by 12.3%) (refer to the definition of same-store sales in the discussion of revenues below) • Thirteen newly acquired clubs contributed $11.8 million to revenues, while a newly constructed Bombshells contributed $1.7 million • Basic and diluted earnings per share (“EPS”) of $1.48 compared to $1.37 (non-GAAP diluted EPS* of $1.60 compared to $1.36) during the comparable prior-year period • Net cash provided by operating activities of $18.9 million compared to $15.0 million during the comparable prior-year period, a 26.2% increase (free cash flow* of $18.0 million compared to $13.0 million, a 39.1% increase) Year-to-Date 2022 • Total revenues were $196.2 million compared to $140.3 million during the comparable prior-year period, a 39.9% increase (Nightclubs revenue of $149.6 million compared to $97.0 million, a 54.2% increase; and Bombshells revenue of $45.9 million compared to $42.2 million, a 8.7% increase) • Consolidated same-store sales increased by 8.4% (Nightclubs increased by 13.2% while Bombshells decreased by 1.6%) (refer to the definition of same-store sales in the discussion of Revenues below) • Thirteen newly acquired clubs contributed $27.0 million to revenues, while a newly constructed Bombshells contributed $4.3 million • Basic and diluted EPS of $3.76 compared to $3.11 (non-GAAP diluted EPS* of $3.89 compared to $2.50) during the comparable prior-year period • Net cash provided by operating activities of $46.8 million compared to $32.2 million during the comparable prior-year period, a 45.1% increase (free cash flow* of $44.4 million compared to $27.6 million, a 60.7% increase) * Reconciliation and discussion of non-GAAP financial measures are included in the “Non-GAAP Financial Measures” section below. 29 Table of Contents Three Months Ended June 30, 2022 Compared to Three Months Ended June 30, 2021 The following table summarizes our results of operations for the three months ended June 30, 2022 and 2021 (dollars in thousands): For the Three Months Ended June 30, 2022 For the Three Months Ended June 30, 2021 Better (Worse) Amount % of Revenues Amount % of Revenues Amount % Revenues Sales of alcoholic beverages $ 29,738 42.1 % $ 25,092 43.4 % $ 4,646 18.5 % Sales of food and merchandise 11,574 16.4 % 12,058 20.8 % (484) (4.0) % Service revenues 25,444 36.0 % 16,880 29.2 % 8,564 50.7 % Other 3,958 5.6 % 3,830 6.6 % 128 3.3 % Total revenues 70,714 100.0 % 57,860 100.0 % 12,854 22.2 % Operating expenses Cost of goods sold Alcoholic beverages sold 5,177 17.4 % 4,621 18.4 % (556) (12.0) % Food and merchandise sold 3,959 34.2 % 4,043 33.5 % 84 2.1 % Service and other 46 0.2 % 208 1.0 % 162 77.9 % Total cost of goods sold (exclusive of items shown separately below) 9,182 13.0 % 8,872 15.3 % (310) (3.5) % Salaries and wages 17,387 24.6 % 13,870 24.0 % (3,517) (25.4) % Selling, general and administrative 19,572 27.7 % 14,697 25.4 % (4,875) (33.2) % Depreciation and amortization 2,565 3.6 % 2,057 3.6 % (508) (24.7) % Other charges (gains), net 1,501 2.1 % (143) (0.2) % (1,644) (1149.7) % Total operating expenses 50,207 71.0 % 39,353 68.0 % (10,854) (27.6) % Income from operations 20,507 29.0 % 18,507 32.0 % 2,000 10.8 % Other income (expenses) Interest expense (3,028) (4.3) % (2,281) (3.9) % (747) (32.7) % Interest income 103 0.1 % 72 0.1 % 31 43.1 % Non-operating gains, net 127 0.2 % 9 — % 118 1311.1 % Income before income taxes 17,709 25.0 % 16,307 28.2 % 1,402 8.6 % Income tax expense 3,767 5.3 % 3,986 6.9 % 219 5.5 % Net income $ 13,942 19.7 % $ 12,321 21.3 % $ 1,621 13.2 % * Percentages may not foot due to rounding. Percentage of revenue for individual cost of goods sold items pertains to their respective revenue line. Revenues Consolidated revenues for the third quarter increased by approximately $12.9 million, or 22.2%, versus the comparable prior-year quarter due primarily to partial recovery from the COVID-19 pandemic and sales from newly acquired clubs and a new Bombshells opening. Consolidated same-store sales decreased by 0.1%. The total increase in consolidated revenues was primarily from a 23.4% increase from new units and partially offset by a 0.1% decrease from last year’s COVID-19 closures, a 0.1% decrease from the impact of same-store sales growth, and a 1.0% decrease from non-core operations. We calculate same-store sales by comparing year-over-year revenues from nightclubs and restaurants/sports bars starting in the first full quarter of operations after at least 12 full months for Nightclubs and at least 18 full months for Bombshells. We consider the first six months of operations of a Bombshells unit to be the “honeymoon period” where sales are significantly higher than normal. We exclude from a particular month’s calculation units previously included in the same-store sales base that have closed temporarily for more than 15 days until its next full month of operations. We also exclude from the same-store sales base units that are being reconcepted or are closed due to renovations or remodels. Acquired 30 Table of Contents units are included in the same-store sales calculation as long as they qualify based on the definition stated above. Revenues outside of our Nightclubs and Bombshells reportable segments are excluded from same-store sales calculation. Segment contribution to total revenues was as follows (in thousands): For the Three Months Ended June 30, 2022 2021 Nightclubs $ 54,684 $ 41,031 Bombshells 15,789 16,077 Other 241 752 $ 70,714 $ 57,860 Nightclubs revenues increased by 33.3% for the quarter ended June 30, 2022 compared to the prior-year quarter primarily due to the contribution of newly acquired clubs and the impact of the increase in same-store sales. For Nightclubs that were open enough days to qualify for same-store sales (refer to the definition of same-store sales in the preceding paragraph), sales increased by 4.8%. Newly acquired clubs contributed $11.8 million to the total Nightclubs revenue increase of $13.7 million. By type of revenue, service revenue increased by 50.8%, alcoholic beverage sales increased by 30.6%, and food, merchandise and other revenue increased by 2.5%. Bombshells revenues decreased by 1.8%, of which 12.3% was for same-store sales decrease with the offsetting increase caused by one new location. By type of revenue, food and merchandise sales were flat while alcoholic beverage sales decreased by 3.2%. Operating Expenses Total operating expenses, as a percent of revenues, increased to 71.0% from 68.0% from last year’s third quarter, with a $10.9 million increase, or 27.6%, which was mainly caused by costs and expenses directly related to significantly higher sales in the current-year quarter and additional fixed expenses partly from new units plus the impairment charge in the current quarter. Significant contributors to the changes in operating expenses are explained below. Cost of goods sold increased by $310,000, or 3.5%, mainly due to higher sales but offset by the mix of higher-margin service revenue increasing from 29.2% to 36.0%. As a percent of total revenues, cost of goods sold decreased to 13.0% from 15.3% mainly due to the sales mix shift mentioned above. Salaries and wages increased by $3.5 million, or 25.4%, due to increase in personnel and shifts to accommodate the increase in sales. As a percent of total revenues, salaries and wages were 24.6% from 24.0% mainly due to additional employees from new units partially offset by fixed salaries paid on higher sales. Selling, general and administrative expenses increased by $4.9 million, or 33.2%, primarily due to increased variable expenses related to sales activity during the current-year quarter and other increases from insurance, accounting and professional fees, and advertising. Depreciation and amortization increased by $508,000, or 24.7% due to new depreciable assets from newly acquired and constructed units. Other charges, net was a net charge of $1.5 million in the current quarter while a net gain of $143,000 in the comparable prior-year quarter. The swing was mainly from impairment charges of $1.7 million in the current third quarter. Income (Loss) from Operations For the three months ended June 30, 2022 and 2021, our consolidated operating margin was 29.0% and 32.0%, respectively. The main drivers for the decrease in operating margin are the presence of less variable costs and expenses such as impairment charge, insurance, and accounting and professional fees, partially offset by the increase in mix of higher-margin service revenue. 31 Table of Contents Segment contribution to income (loss) from operations is presented in the table below (in thousands): For the Three Months Ended June 30, 2022 2021 Nightclubs $ 22,459 $ 18,350 Bombshells 3,065 4,404 Other (82) 321 General corporate (4,935) (4,568) $ 20,507 $ 18,507 Nightclubs operating margin was 41.1% and 44.7% for the three months ended June 30, 2022 and 2021, respectively, while operating margin for Bombshells was 19.4% and 27.4%, respectively. The decreases in both Nightclubs and Bombshells operating margin were mainly due to increases in salaries and wages and certain selling, general and administrative expenses plus the impairment charge. Excluding certain items, non-GAAP operating income (loss) and non-GAAP operating margin are computed in the tables below (dollars in thousands). Refer to the discussion of Non-GAAP Financial Measures on page 36. For the Three Months Ended June 30, 2022 Nightclubs Bombshells Other Corporate Total Income (loss) from operations $ 22,459 $ 3,065 $ (82) $ (4,935) $ 20,507 Amortization of intangibles 23 1 — 1 25 Settlement of lawsuits 124 8 — — 132 Impairment of assets 1,072 650 — — 1,722 Gain on sale of businesses and assets (264) — — (2) (266) Gain on insurance (87) — — — (87) Non-GAAP operating income (loss) $ 23,327 $ 3,724 $ (82) $ (4,936) $ 22,033 GAAP operating margin 41.1 % 19.4 % (34.0) % (7.0) % 29.0 % Non-GAAP operating margin 42.7 % 23.6 % (34.0) % (7.0) % 31.2 % For the Three Months Ended June 30, 2021 Nightclubs Bombshells Other Corporate Total Income (loss) from operations $ 18,350 $ 4,404 $ 321 $ (4,568) $ 18,507 Amortization of intangibles 47 4 — — 51 Settlement of lawsuits 123 4 — — 127 Impairment of assets 271 — — — 271 Loss (gain) on sale of businesses and assets (512) 9 — (38) (541) Non-GAAP operating income (loss) $ 18,279 $ 4,421 $ 321 $ (4,606) $ 18,415 GAAP operating margin 44.7 % 27.4 % 42.7 % (7.9) % 32.0 % Non-GAAP operating margin 44.5 % 27.5 % 42.7 % (8.0) % 31.8 % Other Income/Expenses Interest expense increased by $747,000, or 32.7%, primarily caused by a higher average debt balance and partially offset by a lower average interest rate. Our total occupancy costs, defined as the sum of operating lease expense and interest expense, were $4.8 million and $3.3 million for the quarters ended June 30, 2022 and 2021, respectively. As a percentage of revenue, total occupancy costs 32 Table of Contents were 6.7% and 5.7% during the quarters ended June 30, 2022 and 2021, respectively, primarily due to the interest from higher average debt balance and the increased mix of our clubs where we lease our locations from third parties. Income Taxes Income tax expense was $3.8 million during the quarter ended June 30, 2022 compared to $4.0 million during the quarter ended June 30, 2021. The effective income tax rate was 21.3% and 24.4% for the quarters ended June 30, 2022 and 2021, respectively. Our effective tax rate is affected by state taxes, permanent differences, and tax credits, including the FICA tip credit, for both years, as presented below. For the Three Months Ended June 30, 2022 2021 Federal statutory income tax expense 21.0 % 21.0 % State income taxes, net of federal benefit 2.9 % 4.8 % Permanent differences 0.4 % (0.1) % Tax credit (3.2) % (1.2) % Other 0.1 % — % Total income tax expense 21.3 % 24.4 % 33 Table of Contents Nine Months Ended June 30, 2022 Compared to Nine Months Ended June 30, 2021 The following table summarizes our results of operations for the nine months ended June 30, 2022 and 2021 (dollars in thousands): For the Nine Months Ended June 30, 2022 For the Nine Months Ended June 30, 2021 Better (Worse) Amount % of Revenues Amount % of Revenues Amount % Revenues Sales of alcoholic beverages $ 83,504 42.6 % $ 62,725 44.7 % $ 20,779 33.1 % Sales of food and merchandise 33,628 17.1 % 30,205 21.5 % 3,423 11.3 % Service revenues 67,821 34.6 % 38,442 27.4 % 29,379 76.4 % Other 11,289 5.8 % 8,945 6.4 % 2,344 26.2 % Total revenues 196,242 100.0 % 140,317 100.0 % 55,925 39.9 % Operating expenses Cost of goods sold Alcoholic beverages sold 14,907 17.9 % 11,613 18.5 % (3,294) (28.4) % Food and merchandise sold 11,756 35.0 % 9,961 33.0 % (1,795) (18.0) % Service and other 170 0.2 % 304 0.6 % 134 44.1 % Total cost of goods sold (exclusive of items shown separately below) 26,833 13.7 % 21,878 15.6 % (4,955) (22.6) % Salaries and wages 50,422 25.7 % 36,556 26.1 % (13,866) (37.9) % Selling, general and administrative 56,495 28.8 % 39,467 28.1 % (17,028) (43.1) % Depreciation and amortization 7,636 3.9 % 6,197 4.4 % (1,439) (23.2) % Other charges (gains), net 1,357 0.7 % 1,288 0.9 % (69) (5.4) % Total operating expenses 142,743 72.7 % 105,386 75.1 % (37,357) (35.4) % Income from operations 53,499 27.3 % 34,931 24.9 % 18,568 53.2 % Other income (expenses) Interest expense (8,496) (4.3) % (7,079) (5.0) % (1,417) (20.0) % Interest income 321 0.2 % 194 0.1 % 127 65.5 % Non-operating gains, net 211 0.1 % 5,356 3.8 % (5,145) (96.1) % Income before income taxes 45,535 23.2 % 33,402 23.8 % 12,133 36.3 % Income tax expense 10,056 5.1 % 5,540 3.9 % (4,516) (81.5) % Net income $ 35,479 18.1 % $ 27,862 19.9 % $ 7,617 27.3 % * Percentages may not foot due to rounding. Percentage of revenue for individual cost of goods sold items pertains to their respective revenue line. Revenues Consolidated revenues for the nine months ended June 30, 2022 increased by approximately $55.9 million, or 39.9%, versus to the comparable prior-year period due primarily to partial recovery from the COVID-19 pandemic and sales from newly acquired clubs and a new Bombshells opening. Consolidated same-store sales increased by 8.4%. The 39.9% increase in consolidated revenues was primarily from a 22.3% increase from new units, a 9.9% increase from last year’s COVID-19 closures, a 7.9% increase from the impact of same-store sales growth, with a partially offsetting 0.2% decrease from non-core operations. Refer to the definition of same-store sales in the Revenues section of the third quarter discussion above. 34 Table of Contents Segment contribution to total revenues was as follows (in thousands): For the Nine Months Ended June 30, 2022 2021 Nightclubs $ 149,639 $ 97,015 Bombshells 45,893 42,218 Other 710 1,084 $ 196,242 $ 140,317 Nightclubs revenues increased by 54.2% for the nine months ended June 30, 2022 compared to the comparable prior-year period, where the prior-year first quarter was still heavily impacted by government restrictions related to COVID-19. For Nightclubs that were open enough days to qualify for same-store sales (refer to the definition of same-store sales in the preceding paragraph), sales increased by 13.2%. Newly acquired clubs contributed $27.0 million to the total Nightclubs revenue increase of $52.6 million. By type of revenue, service revenue increased by 76.6%, alcoholic beverage sales increased by 50.8%, and food, merchandise and other revenue increased by 18.9%. Bombshells revenues increased by 8.7%, of which 1.6% was from an offsetting same-store sales decrease with the remaining 10.3% increase caused by one new location. By type of revenue, food, merchandise and other revenue increased by 13.4% while alcoholic beverages sales increased by 5.2%. Operating Expenses Total operating expenses, as a percent of revenues, decreased to 72.7% from 75.1% from last year’s nine-month period, although there was an $37.4 million increase, or 35.4%, which was mainly caused by costs and expenses directly related to significantly higher sales in the current nine-month period. Significant contributors to the changes in operating expenses are explained below. Cost of goods sold increased by $5.0 million, or 22.6%, mainly due to higher sales. As a percent of total revenues, cost of goods sold decreased to 13.7% from 15.6% mainly due to the increase in sales mix of higher-margin service revenues. Salaries and wages increased by $13.9 million, or 37.9%, due to increase in personnel and shifts to accommodate the increase in sales. As a percent of total revenues, salaries and wages were 25.7% from 26.1% mainly due to fixed salaries paid on higher sales partially offset by additional employees from new units. Selling, general and administrative expenses increased by $17.0 million, or 43.1%, primarily due to increased variable expenses related to sales activity during the current period. Depreciation and amortization increased by $1.4 million, or 23.2% due to new depreciable assets from newly acquired and constructed units partially offset by fully depreciated and sold assets. Income (Loss) from Operations For the nine months ended June 30, 2022 and 2021, our consolidated operating margin was 27.3% and 24.9%, respectively. The main drivers for the increase in operating margin are the increase in mix of higher-margin service revenue and the leveraging of fixed expenses on higher sales. Segment contribution to income (loss) from operations is presented in the table below (in thousands): For the Nine Months Ended June 30, 2022 2021 Nightclubs $ 60,321 $ 37,313 Bombshells 9,335 10,263 Other (159) 107 General corporate (15,998) (12,752) $ 53,499 $ 34,931 35 Table of Contents Nightclubs operating margin was 40.3% and 38.5% for the nine months ended June 30, 2022 and 2021, respectively, while operating margin for Bombshells was 20.3% and 24.3%, respectively. The increase in Nightclubs operating margin was mainly due to the increase in higher-margin service revenues and the leveraging of fixed operating costs and expenses in relation to higher sales. The decrease in Bombshells operating margin was mainly from preopening expenses related to the new Bombshells unit and the impairment in the current year. Excluding certain items, non-GAAP operating income (loss) and non-GAAP operating margin are computed in the tables below (dollars in thousands). Refer to the discussion of Non-GAAP Financial Measures on page 36. For the Nine Months Ended June 30, 2022 Nightclubs Bombshells Other Corporate Total Income (loss) from operations $ 60,321 $ 9,335 $ (159) $ (15,998) $ 53,499 Amortization of intangibles 117 5 — 2 124 Settlement of lawsuits 578 18 — 113 709 Impairment of assets 1,072 650 — — 1,722 Loss (gain) on sale of businesses and assets (344) 17 — (339) (666) Gain on insurance (408) — — — (408) Non-GAAP operating income (loss) $ 61,336 $ 10,025 $ (159) $ (16,222) $ 54,980 GAAP operating margin 40.3 % 20.3 % (22.4) % (8.2) % 27.3 % Non-GAAP operating margin 41.0 % 21.8 % (22.4) % (8.3) % 28.0 % For the Nine Months Ended June 30, 2021 Nightclubs Bombshells Other Corporate Total Income (loss) from operations $ 37,313 $ 10,263 $ 107 $ (12,752) $ 34,931 Amortization of intangibles 141 11 57 — 209 Settlement of lawsuits 237 38 5 — 280 Impairment of assets 1,672 — — — 1,672 Loss (gain) on sale of businesses and assets (498) 56 — (13) (455) Gain on insurance (165) — — (44) (209) Non-GAAP operating income (loss) $ 38,700 $ 10,368 $ 169 $ (12,809) $ 36,428 GAAP operating margin 38.5 % 24.3 % 9.9 % (9.1) % 24.9 % Non-GAAP operating margin 39.9 % 24.6 % 15.6 % (9.1) % 26.0 % Other Income/Expenses Interest expense increased by $1.4 million, or 20.0%, which was mainly caused by a higher average debt balance and partially offset by a lower average interest rate. Our total occupancy costs, defined as the sum of operating lease expense and interest expense, were $13.4 million and $10.0 million for the nine months ended June 30, 2022 and 2021, respectively. As a percentage of revenue, total occupancy costs were 6.9% and 7.1% during the nine months ended June 30, 2022 and 2021, respectively, primarily due to the increase in sales base partially offset by higher interest expense from higher average debt balance and more leased properties from new acquisitions. Non-operating gains decreased by $5.1 million, which was primarily the gain on debt extinguishment from the PPP loans during last year's first quarter. Income Taxes Income tax expense was $10.1 million during the nine months ended June 30, 2022 compared to $5.5 million during the comparable prior-year period. The effective income tax rate was 22.1% and 16.6% for the nine months ended June 30, 2022 and 2021, respectively. Our effective tax rate is affected by state taxes, permanent differences, and tax credits, 36 Table of Contents including the FICA tip credit, for both years, and the change in the deferred tax asset valuation allowance and the impact of the forgiveness of the PPP loans in the prior period, as presented below. For the Nine Months Ended June 30, 2022 2021 Computed expected income tax expense 21.0 % 21.0 % State income taxes, net of federal benefit 2.9 % 4.9 % Permanent differences 0.4 % (3.7) % Change in valuation allowance — % (3.8) % Tax credit (2.8) % (1.8) % Other 0.5 % — % Total income tax expense 22.1 % 16.6 % Non-GAAP Financial Measures In addition to our financial information presented in accordance with GAAP, management uses certain non-GAAP financial measures, within the meaning of the SEC Regulation G, to clarify and enhance understanding of past performance and prospects for the future. Generally, a non-GAAP financial measure is a numerical measure of a company’s operating performance, financial position or cash flows that excludes or includes amounts that are included in or excluded from the most directly comparable measure calculated and presented in accordance with GAAP. We monitor non-GAAP financial measures because it describes the operating performance of the Company and helps management and investors gauge our ability to generate cash flow, excluding (or including) some items that management believes are not representative of the ongoing business operations of the Company, but are included in (or excluded from) the most directly comparable measures calculated and presented in accordance with GAAP. Relative to each of the non-GAAP financial measures, we further set forth our rationale as follows: Non-GAAP Operating Income and Non-GAAP Operating Margin. We calculate non-GAAP operating income and non-GAAP operating margin by excluding the following items from income from operations and operating margin: (a) amortization of intangibles, (b) gains or losses on sale of businesses and assets, (c) gains or losses on insurance, (d) settlement of lawsuits, and (e) impairment of assets. We believe that excluding these items assists investors in evaluating period-over-period changes in our operating income and operating margin without the impact of items that are not a result of our day-to-day business and operations. Non-GAAP Net Income and Non-GAAP Net Income per Diluted Share . We calculate non-GAAP net income and non-GAAP net income per diluted share by excluding or including certain items to net income attributable to RCIHH common stockholders and diluted earnings per share. Adjustment items are: (a) amortization of intangibles, (b) impairment of assets, (c) gains or losses on sale of businesses and assets, (d) gains or losses on insurance, (e) unrealized gains or losses on equity securities, (f) settlement of lawsuits, (g) gain on debt extinguishment, and (h) the income tax effect of the above-described adjustments. Included in the income tax effect of the above adjustments is the net effect of the non-GAAP provision for income taxes, calculated at 21.6% and 24.3% effective tax rate of the pre-tax non-GAAP income before taxes for the nine months ended June 30, 2022 and 2021, respectively, and the GAAP income tax expense (benefit). We believe that excluding and including such items help management and investors better understand our operating activities. Adjusted EBITDA . We calculate adjusted EBITDA by excluding the following items from net income attributable to RCIHH common stockholders: (a) depreciation and amortization, (b) income tax expense (benefit), (c) net interest expense, (d) gains or losses on sale of businesses and assets, (e) gains or losses on insurance, (f) unrealized gains or losses on equity securities, (g) impairment of assets, (h) settlement of lawsuits, and (i) gain on debt extinguishment. We believe that adjusting for such items helps management and investors better understand our operating activities. Adjusted EBITDA provides a core operational performance measurement that compares results without the need to adjust for federal, state and local taxes which have considerable variation between domestic jurisdictions. The results are, therefore, without consideration of financing alternatives of capital employed. We use adjusted EBITDA as one guideline to assess our unleveraged performance return on our investments. Adjusted EBITDA is also the target benchmark for our acquisitions of nightclubs. We also use certain non-GAAP cash flow measures such as free cash flow. See “Liquidity and Capital Resources” section for further discussion. 37 Table of Contents The following tables present our non-GAAP performance measures for the three and nine months ended June 30, 2022 and 2021 (in thousands, except per share, number of shares and percentages): Three Months Ended June 30, Nine Months Ended June 30, 2022 2021 2022 2021 Reconciliation of GAAP net income to Adjusted EBITDA Net income attributable to RCIHH common stockholders $ 13,902 $ 12,302 $ 35,429 $ 28,036 Income tax expense 3,767 3,986 10,056 5,540 Interest expense, net 2,925 2,209 8,175 6,885 Settlement of lawsuits 132 127 709 280 Impairment of assets 1,722 271 1,722 1,672 Gain on sale of businesses and assets (266) (541) (666) (455) Gain on debt extinguishment (53) — (138) (5,329) Unrealized loss (gain) on equity securities — (9) 1 58 Gain on insurance (87) — (408) (209) Depreciation and amortization 2,565 2,057 7,636 6,197 Adjusted EBITDA $ 24,607 $ 20,402 $ 62,516 $ 42,675 Reconciliation of GAAP net income to non-GAAP net income Net income attributable to RCIHH common stockholders $ 13,902 $ 12,302 $ 35,429 $ 28,036 Amortization of intangibles 25 51 124 209 Settlement of lawsuits 132 127 709 280 Impairment of assets 1,722 271 1,722 1,672 Gain on sale of businesses and assets (266) (541) (666) (455) Gain on debt extinguishment (53) — (138) (5,329) Unrealized loss (gain) on equity securities — (9) 1 58 Gain on insurance (87) — (408) (209) Net income tax effect (312) 39 (59) (1,702) 38 Table of Contents Non-GAAP net income $ 15,063 $ 12,240 $ 36,714 $ 22,560 Reconciliation of GAAP diluted earnings per share to non-GAAP diluted earnings per share Diluted shares 9,389,675 8,999,910 9,428,461 9,006,373 GAAP diluted earnings per share $ 1.48 $ 1.37 $ 3.76 $ 3.11 Amortization of intangibles 0.00 0.01 0.01 0.02 Settlement of lawsuits 0.01 0.01 0.08 0.03 Impairment of assets 0.18 0.03 0.18 0.19 Gain on sale of businesses and assets (0.03) (0.06) (0.07) (0.05) Gain on debt extinguishment (0.01) 0.00 (0.01) (0.59) Unrealized loss (gain) on equity securities 0.00 0.00 0.00 0.01 Gain on insurance (0.01) 0.00 (0.04) (0.02) Net income tax effect (0.03) 0.00 (0.01) (0.19) Non-GAAP diluted earnings per share $ 1.60 $ 1.36 $ 3.89 $ 2.50 Reconciliation of GAAP operating income to non-GAAP operating income Income from operations $ 20,507 $ 18,507 $ 53,499 $ 34,931 Amortization of intangibles 25 51 124 209 Settlement of lawsuits 132 127 709 280 Impairment of assets 1,722 271 1,722 1,672 Gain on sale of businesses and assets (266) (541) (666) (455) Gain on insurance (87) — (408) (209) Non-GAAP operating income $ 22,033 $ 18,415 $ 54,980 $ 36,428 Reconciliation of GAAP operating margin to non-GAAP operating margin Income from operations 29.0 % 32.0 % 27.3 % 24.9 % Amortization of intangibles 0.0 % 0.1 % 0.1 % 0.1 % Settlement of lawsuits 0.2 % 0.2 % 0.4 % 0.2 % Impairment of assets 2.4 % 0.5 % 0.9 % 1.2 % Gain on sale of businesses and assets (0.4) % (0.9) % (0.3) % (0.3) % Gain on insurance (0.1) % 0.0 % (0.2) % (0.1) % Non-GAAP operating margin 31.2 % 31.8 % 28.0 % 26.0 % * Per share amounts and percentages may not foot due to rounding. The adjustments to reconcile net income attributable to RCIHH common stockholders to non-GAAP net income exclude the impact of adjustments related to noncontrolling interests, which is immaterial. Liquidity and Capital Resources At June 30, 2022, our cash and cash equivalents were approximately $37.5 million compared to $35.7 million at September 30, 2021. Because of the large volume of cash we handle, we have very stringent cash controls. As of June 30, 2022, we had working capital of $20.5 million compared to working capital of $26.1 million as of September 30, 2021, excluding net assets held for sale (net of associated liabilities of $4.2 million and $1.1 million, respectively) amounting to $2.7 million and $3.8 million as of June 30, 2022 and September 30, 2021, respectively. Although we believe that our ability to generate cash from operating activities is one of our fundamental financial strengths, the temporary closure of our clubs and restaurants caused by the COVID-19 pandemic presented operational challenges. Our strategy was to open locations and operate in accordance with local and state guidelines. Revenues seem favorable now that all our locations are not under 39 Table of Contents pandemic-related closure mandates. We believe that we can borrow capital if needed but currently we do not have unused credit facilities so there can be no guarantee that additional liquidity will be readily available or available on favorable terms. We continue to adhere to state and local government mandates regarding the pandemic and, since March 2020, have closed and reopened a number of our locations depending on changing government mandates, including operating hour and limited occupancy restrictions, where applicable. Currently, all of our locations are open except one club that is being renovated and/or remodeled. We have not recently raised capital through the issuance of equity securities although we have recently issued shares of our common stock to partly pay for an acquisition (see next paragraph). Instead, we use debt financing to lower our overall cost of capital and increase our return on stockholders’ equity. We have a history of borrowing funds in private transactions and from sellers in acquisition transactions and have secured traditional bank financing on our new development projects and refinancing of our existing notes payable, but with the significant global impact of the COVID-19 pandemic, there can be no assurance that any of these financing options would be presently available on favorable terms, if at all. We also have historically utilized these cash flows to invest in property and equipment, adult nightclubs, and restaurants/sports bars. On October 18, 2021, we and certain of our subsidiaries completed our acquisition of eleven gentlemen’s clubs, six related real estate properties, and associated intellectual property for a total agreed acquisition price of $88.0 million (with a total consideration preliminary fair value of $88.4 million based on the Company’s stock price at acquisition date and discounted due to the lock-up period). The acquisition gives the Company presence in four additional states. We paid for the acquisition with $36.8 million in cash, $21.2 million in four seller-financed notes, and 500,000 shares of our common stock with a fair value of $30.4 million at issuance. On January 25, 2022, the Company borrowed $18.7 million from a bank lender for working capital purposes by executing a 10-year promissory note with an initial interest rate of 5.25% per annum to be adjusted after five years to a rate equal to the weekly average yield on U.S. Treasury securities plus 3.98% with a floor of 5.25%. The note is payable in monthly payments of $126,265 in principal and interest to be adjusted after five years. The promissory note is secured by eleven real estate properties. After the 10-year term, the remaining balance of principal and interest are payable at maturity date. There are certain financial covenants with which the Company is to be in compliance related to this loan, among which to maintain a debt service coverage of not less than 1.4 times, reviewed annually . On May 2, 2022, the Company completed an acquisition of a club in Miami, Florida for a total acquisition price of $16.0 million. The acquisition price includes $3.0 million for the real estate property covered in a stock purchase agreement payable in cash at closing, and $13.0 million for the adult entertainment business covered in a separate stock purchase agreement payable as follows: (1) $2.0 million in cash at closing; (2) $6.0 million under a 10% three-year promissory note payable in 35 equal monthly payments of $79,290 in principal and interest based on a ten-year amortization schedule, with a balloon payment for the remaining principal and accrued interest due at maturity; and (3) $5.0 million under a 10% ten-year interest-only promissory note payable in 119 equal monthly payments of $41,667 in interest, with a balloon payment of the total $5.0 million in principal plus accrued interest due at maturity. The $5.0 million promissory note may be earlier canceled if there are any regulatory changes that would prohibit the business from operating as an adult entertainment establishment within ten years of the closing date of the stock purchase agreement. We expect to generate adequate cash flows from operations for the next 12 months from the issuance of this report. The following table presents a summary of our cash flows from operating, investing, and financing activities (in thousands): For the Nine Months Ended June 30, 2022 2021 Operating activities $ 46,754 $ 32,217 Investing activities (56,222) (7,186) Financing activities 11,282 (11,568) Net increase in cash and cash equivalents $ 1,814 $ 13,463 40 Table of Contents Cash Flows from Operating Activities Following are our summarized cash flows from operating activities (in thousands): For the Nine Months Ended June 30, 2022 2021 Net income $ 35,479 $ 27,862 Depreciation and amortization 7,636 6,197 Deferred income tax benefit (409) (430) Impairment of assets 1,722 1,672 Gain on debt extinguishment (83) (5,298) Net change in operating assets and liabilities 1,421 1,656 Other 988 558 Net cash provided by operating activities $ 46,754 $ 32,217 Net cash provided by operating activities increased from year to year primarily driven by the impact of higher sales partially offset by higher interest expense and income taxes paid. Cash Flows from Investing Activities Following are our cash flows from investing activities (in thousands): For the Nine Months Ended June 30, 2022 2021 Payments for property and equipment and intangible assets $ (17,173) $ (10,788) Acquisition of businesses (44,302) — Proceeds from sale of businesses and assets 4,611 3,213 Proceeds from insurance 515 294 Proceeds from notes receivable 127 95 Net cash used in investing activities $ (56,222) $ (7,186) Following is a breakdown of our payments for property and equipment and intangible assets for the nine months ended June 30, 2022 and 2021 (in thousands): For the Nine Months Ended June 30, 2022 2021 New facilities, equipment, and intangible assets $ 14,788 $ 6,180 Maintenance capital expenditures 2,385 4,608 Total capital expenditures $ 17,173 $ 10,788 The capital expenditures during the nine months ended June 30, 2022 were composed of primarily of real estate and new equipment and furniture purchases for the newly acquired clubs. The capital expenditures during the nine months ended June 30, 2021 were composed of primarily of real estate and construction of one new Bombshells location, a newly renovated club that was damaged by hurricane, and a liquor license purchase. Maintenance capital expenditures refer mainly to capitalized replacement of productive assets in already existing locations. Variances in capital expenditures are primarily due to the number and timing of new, remodeled, or reconcepted locations under construction. 41 Table of Contents Cash Flows from Financing Activities Following are our cash flows from financing activities (in thousands): For the Nine Months Ended June 30, 2022 2021 Proceeds from debt obligations $ 35,820 $ 2,176 Payments on debt obligations (10,714) (10,845) Purchase of treasury stock (12,057) (1,794) Payment of dividends (1,322) (1,080) Payment of loan origination costs (445) (25) Net cash provided by (used in) financing activities $ 11,282 $ (11,568) We purchased 213,712 shares of our common stock at an average price of $56.42 during the nine months ended June 30, 2022, while we purchased 74,659 shares of our common stock at an average price of $24.03 during the nine months ended June 30, 2021. On May 24, 2022, the Board of Directors approved a $25.0 million increase in the Company's share repurchase program. As of June 30, 2022, we have approximately $21.9 million remaining to purchase additional shares. Subsequent to the reporting date until August 5, 2022, the Company purchased 42,250 shares of its own common stock at a cost of $2.3 million. We paid quarterly dividends of $0.04 per share in both the current- and prior-year periods, except for the second and third quarters of fiscal 2022 where we paid $0.05 per share. See Note 7 to our unaudited condensed consolidated financial statements for future maturities of our debt obligations. Management also uses certain non-GAAP cash flow measures such as free cash flow. We calculate free cash flow as net cash provided by operating activities less maintenance capital expenditures. We use free cash flow as the baseline for the implementation of our capital allocation strategy. Below is a table reconciling free cash flow to its most directly comparable GAAP measure (in thousands): For the Nine Months Ended June 30, 2022 2021 Net cash provided by operating activities $ 46,754 $ 32,217 Less: Maintenance capital expenditures 2,385 4,608 Free cash flow $ 44,369 $ 27,609 Our free cash flow for the current nine-month period increased by 60.7% compared to the comparable prior-year period primarily due to higher sales, net of related expense payments and lower maintenance capital expenditures, partially offset by higher interest expense payments and higher income tax payments in the current year. We do not include capital expenditures related to new facilities construction, equipment and intangibles assets as a reduction from net cash flow from operating activities to arrive at free cash flow. This is because, based on our capital allocation strategy, acquisitions and development of our own clubs and restaurants are our primary uses of free cash flow. Other than the potentially prolonged effect of the COVID-19 pandemic, the potential economic slowdown, and the notes payable financing described above, we are not aware of any event or trend that would potentially significantly affect liquidity. In our opinion, working capital is not a true indicator of our financial status. Typically, businesses in our industry carry current liabilities in excess of current assets because businesses in our industry receive substantially immediate payment for sales, with nominal receivables, while inventories and other current liabilities normally carry longer payment terms. Vendors and purveyors often remain flexible with payment terms, providing businesses in our industry with opportunities to adjust to short-term business down turns. We consider the primary indicators of financial status to be the long-term trend of revenue growth, the mix of sales revenues, overall cash flow, profitability from operations and the level of long-term debt. 42 Table of Contents The following table presents a summary of such indicators for the nine months ended June 30 (in thousands, except percentages): 2022 Increase (Decrease) 2021 Increase (Decrease) 2020 Sales of alcoholic beverages $ 83,504 33.1 % $ 62,725 38.5 % $ 45,285 Sales of food and merchandise 33,628 11.3 % 30,205 73.8 % 17,378 Service revenues 67,821 76.4 % 38,442 11.6 % 34,448 Other 11,289 26.2 % 8,945 39.1 % 6,430 Total revenues $ 196,242 39.9 % $ 140,317 35.5 % $ 103,541 Net income (loss) attributable to RCIHH common stockholders $ 35,429 26.4 % $ 28,036 (951.6) % $ (3,292) Net cash provided by operating activities $ 46,754 45.1 % $ 32,217 165.2 % $ 12,147 Adjusted EBITDA* $ 62,516 46.5 % $ 42,675 137.4 % $ 17,973 Free cash flow* $ 44,369 60.7 % $ 27,609 175.1 % $ 10,036 Debt (end of period) $ 187,965 47.3 % $ 127,603 (10.6) % $ 142,736 * See definition and calculation of Adjusted EBITDA and Free Cash Flow above in the Non-GAAP Financial Measures subsection of Results of Operations. Impact of Inflation To the extent permitted by competition, we have managed to recover increased costs through price increases and may continue to do so. However, there can be no assurance that we will be able to do so in the future. Seasonality Our nightclub operations are affected by seasonal factors. Historically, we have experienced reduced revenues from April through September (our fiscal third and fourth quarters) with the strongest operating results occurring during October through March (our fiscal first and second quarters). Our revenues in certain markets are also affected by sporting events that cause unusual changes in sales from year to year. Capital Allocation Strategy Our capital allocation strategy provides us with disciplined guidelines on how we should use our free cash flows; provided however, that we may deviate from this strategy if other strategic rationale warrants. We calculate free cash flow as net cash flows from operating activities minus maintenance capital expenditures. Using the after-tax yield of buying our own stock as baseline, management believes that we are able to make better investment decisions. Based on our current capital allocation strategy: • We consider acquiring or developing our own clubs or restaurants that we believe have the potential to provide a minimum cash on cash return of 25%-33%, absent an otherwise strategic rationale; • We consider disposing of underperforming units to free up capital for more productive use; • We consider buying back our own stock if the after-tax yield on free cash flow is above 10%; • We consider paying down our most expensive debt if it makes sense on a tax adjusted basis, or there is an otherwise strategic rationale. Growth Strategy We believe that our nightclub operations can continue to grow organically and through careful entry into markets and demographic segments with high growth potential. Our growth strategy involves the following: (i) to acquire existing units in locations that are consistent with our growth and income targets and which appear receptive to the upscale club formula we have developed; (ii) to open new units after market analysis; (iii) to franchise our Bombshells brand; (iv) to form joint ventures or partnerships to reduce start-up and operating costs, with us contributing equity in the form of our brand name 43 Table of Contents and management expertise; (v) to develop new club concepts that are consistent with our management and marketing skills; (vi) to develop and open our restaurant concepts as our capital and manpower allow; and (vii) to control the real estate in connection with club operations, although some units may be in leased premises. We believe that Bombshells can grow organically and through careful entry into markets and demographic segments with high growth potential. All eleven of the existing company-owned Bombshells as of June 30, 2022 are located in Texas. Our first franchisee for Bombshells restaurants in the San Antonio, Texas area opened in June 2022. Our growth strategy is to diversify our operations with these units which do not require SOB licenses, which are sometimes difficult to obtain. While we are searching for adult nightclubs to acquire, we are able to also search for restaurant/sports bar locations that are consistent with our income targets. We are currently in the process of site selection for new Bombshells locations and made purchases of real estate in Stafford and Rowlett, both in Texas, for future Bombshells sites. We continue to evaluate opportunities to acquire new nightclubs and anticipate acquiring new locations that fit our business model as we have done in the past. The acquisition of additional clubs may require us to take on additional debt or issue our common stock, or both. There can be no assurance that we will be able to obtain additional financing on reasonable terms in the future, if at all, should the need arise. An inability to obtain such additional financing could have an adverse effect on our growth strategy. Item 3. Quantitative and Qualitative Disclosures About Market Risk. As of June 30, 2022, there were no material changes to the information provided in Item 7A of the Company’s Annual Report on Form 10-K for fiscal year ended September 30, 2021.