Description

Variant Thesis

Dave & Buster’s has thus far been a standout performer among JOBS Act IPOs rising roughly 175% from its Oct 2014 IPO at $16/share with strong revenue and EBITDA growth above mgmt’s LT targets the primary driver. But the timing now appears right for the negative shift in the near-universally bullish narrative that has appeared in so many of these JOBS Act IPOs. Variant thesis suggests the run of SSS and non-comp revenue growth and EBITDA flow through above mgmt’s long-term targets will increasingly be viewed as unsustainable as the positive impact from both company-specific actions to facilitate private equity/mgmt exit and highly favorable macro tailwinds diminish. Continued SSS deceleration to a volatile historical +LSD pattern with frequent quarterly declines (each of three years prior to Oct 2014 IPO had a decline) should cause legacy cyclical, consumer relevancy and concept portability concerns to return to the fore. Historically a mediocre business across the cycle as measured by modest ROIC/FCF, the 2008-10 precedent is highlighted by -12.5% cumulative three-year decline in SSS and a virtual halt in unit growth. Already in a four-quarter deceleration trend, even mgmt characterizes the current SSS pattern as “volatile” and recent outsized amusements contribution to SSS (1H food and beverage SSS were both well below +2% LT SSS target in 1H) is eerily similar to the end of the prior cycle (i.e. 1H 2016 looks similar to 1Q 2008).

The consensus bull case is that post-IPO performance above mgmt’s LT targets including a (just-broken) string of seven consecutive “beat-and-raise” quarters since the company’s fortuitously-timed Oct 2014 IPO signal 1) the “highly-differentiated” Eat, Drink, Play, Watch concept is well-positioned to continue to outperform casual-dining peers and sustain unit growth at an accelerated +10% rate; and 2) the brand equity/awareness and SSS/non-comp revenue uplift from remodels, D&B Sports additions and marketing/advertising efficacy (the “brand transformation”) is sustainable. While likely an improved concept (i.e. hefty remodel spend, addition of “Watch”, efficacy of operating initiatives) vs prior cycle, near-universal bullish sentiment and extrapolated estimates appear to ignore material risks including 1) potentially unsustainable unit-growth acceleration to +10% rate given more than 33% of store base is less than five years old and less-profitable, largely unproven small-store format is still just 10% of square footage; 2) diminishing company-specific and macro SSS and non-comp revenue tailwinds including the roll off of honeymoon SSS uplift from $80M remodel/D&B Sports capital cycle, decreasing amount of highly favorable honeymoon square footage within the non-comp base in 2H, waning benefit from macro tailwinds such as lower gas prices and peak employment and customer fatigue from blurred customer targeting and brand inconsistency/lagging execution especially in service and food & beverage; and 3) unsustainable margin enhancement driven largely by flow through and mix shift toward highly discretionary amusements business against slowing SSS/non-comp revenue growth, anniversary of e-ticket benefit, reduced efficiency benefits/higher marketing spend from unprecedented 2015 new opening emphasis on more profitable large format stores in existing markets, upward labor and development/occ’y cost pressures and waning commodity tailwind. With respect to cost pressures mgmt recently indicated 50% target flow through above higher +2% SSS threshold vs +1% at IPO and highlighted reduced operating leverage from slower SSS and margin pressures in 2H.

Non-consensus skeptical view is supported by aggressive insider selling (private equity and mgmt) of 30M shares for more than $1B net proceeds in the last 18 months including CEO, Pres/COO and CFO sales in each of three 2015 secondary offerings eliminating entire pre-IPO share holdings and more than 40% of $4.44-strike options expiring June 2020. These same officers continue to consistently sell $4.44-strike options under 10b-5s implemented in July 2015 with 2015-16 grants largely immaterial to remaining overall value.  

Despite the concept’s checkered capital markets history (a pair of failed IPOs, at least two unsuccessful sale processes) the stock is now +175% from $16 IPO price and trades at high end of its valuation ranges since the IPO or 9x EV/EBITDA (6-10x). Deployment emphasizing growth and dramatic recent increases in maintenance and games refresh cap ex should keep capital intensity high but Street favors optically cheaper EV/EBITDA multiples. LT embedded expectations analysis suggests PLAY is materially overvalued and $32 TP range implies near-30% downside, represents 7.5x below-consensus 2017 EBITDA (every turn equals ~$5.25/share) and is supported by 10-year DCF/EVA/Equity EVA. Primary catalyst is materialization of expected negative dynamics vs expectations including likely continued SSS deceleration off continued unprecedented two-year comps and mean-reversion in EBITDA flow through. Primary risk is continued overperformance vs mgmt’s LT targets (+10% revenue/+LDD EBITDA growth) which would continue to support permanent higher plateau/sustainability-driven bullish narrative.

Historically Mediocre Business Model

Founded in 1982 in Dallas, Texas Dave & Buster’s operates 88 large-format casual dining/entertainment (video and midway games) venues. The entire store base is leased (one third mall-based, one third freestanding and one third in-line) and current senior management has been with the company for ten years. Historical numbers just don’t support the narrative that 34-year-old D&B – which has never sustained +10% annual unit growth and is six years into a macro recovery including the incremental benefit of a -50% decline in gas prices from late 2014 through 2015 – is supposedly now a growth concept that will fill a 200-unit US/Canada whitespace opp’y and expand internationally while continuing to generate consistent +LSD SSS growth and targeted 25% five-year cash-on-cash returns.

It seems clear the concept resonates in a favorable macro environment especially within an amusements or “soft-core gaming” segment that now benefits from 90%+ adoption of stored-value card exchange. But execution and challenging full-cycle economics/return characteristics have tripped up D&B and other similar concepts in the past. The argument that D&B is the only nationally branded multi-purpose dining/entertainment concept may be true but the counter is that these large-format entertainment/dining venues have a consistently poor track record owing to the combination of hefty capital requirements, cyclicality, myriad local competition/high substitution risk and shifting consumer tastes. The large-format entertainment/dining space is littered with high-profile failures seemingly not because the concepts are off point but rather because the execution is so demanding. Historically they have been characterized by strong initial trial and subsequent consumer fatigue as consistency breaks down, target audience becomes blurred, service levels suffer and the value proposition wanes. Acceleration to +10%-unit growth will only exacerbate this execution challenge for a company that has struggled to accelerate growth several times in the past. And the high fixed-cost component of these models has historically made it challenging to withstand shifting consumer tastes or cyclical downturns. With respect to the latter we believe favorable business conditions throughout this extended recovery particularly in the 2014-15 period have contributed to investor complacency regarding risks associated with the underlying model.

D&B was passed between two private equity firms, pursued at least two failed sale processes and attempted two failed IPOs before finally getting public in Oct 2014. Most recent sponsor Oak Hill bought the company at <8x near-trough 2010 EBITDA and planned to commence the exit process within a year. As shown later in this report Oak Hill has already netted proceeds in excess of $1B through heavy post-IPO selling. An analysis of D&B’s trailing track record pre-dating the last recession illustrates the business’ cyclicality, and modest free cash flow and return characteristics. Annual SSS show a highly cyclical pattern that averages just +1.4%. On a trailing 10-year basis (off a base of 48 units in 2006) unit growth was +5.8% and +6.9% on a trailing five-year basis. This drove +6.5% and +10.7% trailing 10-year and five-year revenue CAGRs, respectively.

Store level EBITDA has grown more rapidly at +9.8% and +16.1%, respectively, with the latter five-year growth heavily influenced by unprecedented +23.1% and 28.0% growth in 2014 and 2015, respectively. Notably gross cap ex has grown at a 10.1% CAGR on a trailing 10-year basis but accelerated to +35.8% on a trailing five-year basis.

Unsustainable Recent Overperformance

D&B was among a number of multi-decade old restaurant concepts that pursued JOBS Act IPOs in the 2014-15 period as private equity – with the help of significant macro tailwinds – convinced public-market participants that a number of legacy concepts were now ready to pursue accelerated unit growth strategies. For most of this crop of IPOs the bullish narrative has already unwound, yet D&B has become a standout outperformer by consistently exceeding its financial targets and eventually convincing initially skeptical investors that after 30-plus years it has indeed experienced a “brand transformation.”

Mgmt’s long-term growth targets contemplate +10%-unit growth and +2% SSS growth combining to drive +10% revenue growth owing to larger percentage of small-format new units. Since the model requires +200bps to drive operating leverage contemplated EBITDA growth is roughly in line with revenue growth. Notably mgmt articulated the model could drive 50% flow through (unchanged) above a lower +1% SSS hurdle at the IPO.

Long-Term Management Growth Targets

According to mgmt new D&B locations open with volumes well above run-rate levels ("honeymoon") in year one with a -10-20% revenue decline in year two with an accompanying “up to 400bps” decline in SL margins. The stores then typically comp +LDD in year three and recover ~85% of year one revenues by year five. Year one target is 35% cash-on-cash returns and five-year average cash-on-cash returns in excess of 25%. Notably only in recent disclosure has mgmt taken to describing the honeymoon period as a 26-week phenomenon.

Large format boxes are cheaper to develop and have materially less honeymoon revenue fall off. Not surprisingly mgmt has emphasized large format (14 of 18 openings in 2014-15 including nine of 10 in 2015) and eight of 10 2015 openings were in existing markets. Mgmt has also materially revised revenue and margin assumptions including a 13% increase in small-format revenues despite opening just four stores in the last two years. Development costs are also on the rise.

Relative to mgmt’s long-term targets net unit growth has performed in line averaging +10% in 2014-15; SSS growth has materially outperformed (+7% and +9% in 2014 and 2015, respectively, after being up +1% in 2013); and EBITDA growth has also materially outperformed (+23% in 2014 and +30% in 2015) on EBITDA flow through that accelerated from the low-20s in 2013 to mid-40s in 2015. Net unit growth will eventually trend back sub-10% as the consensus white-space opp’y appears unrealistic and the next cyclical slowdown will again result in a paring back of unit growth. Also look for SSS to continue to decelerate and potentially begin underperforming in the 2H on both visible and less-visible group and company-specific issues. Improving quarterly EBITDA flow through also likely peaked in 1Q 2016 and the model contemplates y/y declines in 2Q-4Q on deteriorating SSS and decreasing mix of honeymoon square footage in the non-comp store base off the outsized 1Q peak.

Recently reported 2Q brought the string of seven consecutive beats and raises to an end. Mixed 2Q and maintained 2016 guide appears supportive of bearish turn in narrative especially when focusing on tells seemingly overlooked or ignored by still-bullish sell-side community.

• Mgmt raised mid-point of SSS guide +75bps from +3.0% to +3.75% on June 7 and subsequently lowered the mid-point back down -100bps to +2.75% or below prior pre-1Q revised mid-point. This suggests mgmt raised for positive optical reasons or visibility is poor given “volatile” weekly comp pattern.

• Mgmt also indicated July was best SSS month of the 2Q which further calls into question why guide was raised on June 7th? And July 2016 also benefitted from two add’l weekend days y/y.  

• PE sponsor Oak Hill and mgmt took advantage of post-1Q guide raise to sell more stock. Oak Hill sold an estimated 1.2M add’l shares from May 1-July 31 taking ownership from 9.6% to 6.5%. Mgmt continued to sell under 10-b5 programs.

• There was no recognition of -16% sequential deceleration in non-comp AWS which is supportive of a 1Q peak in non-comp AWS driven by outsized 72% of non-comp square footage experiencing positive “honeymoon” dynamics vs just over 50% in 2Q. Even with an add’l large-format opening in 2H this mix become increasingly with “honeymoon square footage representing less than 50% of non-comp square footage by 4Q. Recall new units open above LT averages with revenues dropping “-10-20%” and unit-level margins compressing “up to 400bps” in year two.

• Despite mgmt calling out negative Memorial Day shift in retrospect there was no acknowledgement of challenging 2H calendar dynamics (3Q and 4Q have one fewer weekend day each; Halloween appears favorable but key X-mas and NYE shifts appear negative).

• The only use of the hyped $100M share repurchase initiated at 1Q was to purchase 38K shares from a former director (assume it’s one of two Oak Hill directors that left BoD on July 8th) at an estimated near-top $47.60/share.

• Mgmt appeared to acknowledged past-peak operating leverage dynamics with at least +2% SSS required to gain leverage, roll over of e-ticket initiative, reduced commodity deflation tailwind and heavier “investments” including marketing spend. Disclosed hourly wage pressure (~55% of payroll and benefits) of +4.4% was also above prior +4% indicated labor cost guide and +2.5% in 2015.

• Cap ex guide was increased again including a 2nd consecutive increase to games refresh cap ex from $15M to $18M vs $12M initially and up from $10M a year ago. Unchanged maintenance cap ex guide is already +39% y/y to $20M.

• Lastly the language about an initial 2017 int’l opening was taken out of the 10-Q.

Aggressive Insider Selling

Despite two failed attempts to get public D&B rode the wave of 2014-15 JOBS Act restaurant IPOs and completed an all-primary IPO at low end of $16-18 range in Oct 2014 (with the recent $100M repurchase authorization the company can now buy back at triple the price roughly half the IPO shares it issued). Oak Hill has already taken its ownership from 95% pre-IPO to less than 10% currently and booked $935M of proceeds through five liquidity events in the last 18 months. And as of June two Oak Hill Board of Director reps didn’t stand for re-election.

PE Sponsor Oak Hill Insider Selling Since Oct 2014 IPO

Senior mgmt has been busy selling as well. The top three officers disposed of all of their stock holdings as of the second managed offering and have subsequently been selling $4.44-strike options that expire in June 2020. These top three managers alone have netted more than $42M in the last 18 months alone and continue to consistently sell under 10b-5s implemented in summer 2015. While mgmt talks about being “aligned with shareholders” the vast majority of mgmt’s economic interest in D&B is in wildly in-the-money $4.44-strike options not the relatively immaterial 2015 or 2016 grants.

CEO, President/COO and CFO Insider Selling Since Oct 2014 IPO

Valuation Considerations

PLAY is +175% from the $16 IPO price including +5% YTD, +53% in 2015 and +71% in 2014 from the Oct IPO (stock has been consistently working so recency bias is off the charts). Float is now above 90% of shares outstanding. Despite increasingly bearish restaurant sentiment especially in casual dining (PLAY is more discretionary location-based entertainment or LBE concept anyway), sentiment is still bullish (buy ratings from all but one analyst) albeit not surprisingly since coverage is dominated by the original underwriters and D&B has been an impressive fee generator since the IPO through three managed secondary offerings and two overnight deals. The recently ended string of seven consecutive quarterly beats has had the sell side fawning over the “highly differentiated” and “multi-dimensional” business model and revenue, EBITDA and EPS estimates trend uninterrupted up and to the right and still above mgmt’s long-term targets.

A less bullish and far more realistic model shows continued deceleration into 2H especially in highly discretionary amusements business. Negative comps in 2H – show F3Q but could be F4Q especially on negative calendar impact (Halloween looks favorable but X-mas and NYE look negative y/y and each of F3Q-4Q have one fewer weekend day) and continued weakness in special events business. Mgmt has either consistently sand-bagged guide vs expectations to facilitate insider selling at successively higher levels or has limited visibility into continuation/sustainability of recent trends. We suspect the latter as IPO documentation was filed in early 2008 and 1H 2008 SSS were +2.5% while 2H 2008 SSS collapsed to -8.5%.

Current EV of $2.3B includes net debt of $267M and trades at 9.5x consensus F2016 EBITDA or just below peak of the NTM range since October 2014 IPO of 5.7-10.0x and the average of 7.5x. Every turn is ~$5.25/share. EBITDA less net cap ex multiples (including growth cap ex b/c this is a “growth” company) are wholly uninspiring at ~23x this year and next.  P/E multiples also look expensive at a hefty 23x 2016 and 20x 2017 consensus estimates especially for a cyclical LDD +LDD grower best case. EBITDA per unit troughed at $1.4M in 2009 so on a YE2016 base of 94 units PLAY trades at 17x estimated trough EBITDA vs the 8x paid by Oak Hill on near-trough 2010 EBITDA. Ironically at 8x 90-unit trough EBITDA PLAY would trade at $18 per share or in line with the $1.0B EV Oak Hill was apparently seeking when pursuing the pre-IPO sale process and in line with the high end of the initial October 2014 IPO range.  

PLAY already appears overvalued on the unrealistic scenario of uninterrupted growth in line with mgmt’s long-term targets (no cyclicality, no cannibalization, no “competitive intrusion,” cont’d growth over historical-peak AUV). Modeling +10.5% revenue growth (+8.5% sq. footage growth plus +2.0% SSS) and slightly higher 11.0% EBITDA growth and employing an 11.5-12.5% required equity rate of return (given myriad risks) and a 7.5x exit multiple yields current value of $41-44/share and year-forward value of $46-49/share (<10% upside). And beyond historical cyclicality this scenario also appears completely unrealistic since it assumes AUVs – already +19% vs trough – can climb another +21% to $13.4M despite lower-revenue smaller-format stores becoming a greater portion of the mix and likely utilization/throughput issues since reviews suggest peak periods especially in the arcade are already overcrowded. Moreover, this scenario implies D&B would reach 200 units or essentially full penetration in US/Canada (documentation prior to Oct 2014 IPO put full penetration at 150 units) and stable 30%+ SL EBITDA margins that are already +600bps in the last five years.

Base case is much more likely cyclical scenario whereby reduced free cash from negative SSS and subsequent hefty negative operating leverage causes unit growth to decelerate. Modeling +6.0% revenue growth (+5.5% sq. footage growth plus +0.7% SSS) and slightly higher 6.6% EBITDA growth (assumes 2017-18 trough and subsequent recovery) and employing an 11.5-12.5% required equity rate of return and a 7.5x exit multiple yields current value of $25-27/share (-43-39%) and year-forward value of $27-30/share.

Blended fair value appears to be -36-27% lower in the $28-32/share range or 7.5-8.0x below-consensus 2017, 11-12x adjusted trough and ~8x mid-cycle EBITDA. Given the failures in the large-format dining/entertainment space and the company’s cyclical operating history any disappointment would likely be met with a swift change in the bullish “brand transformation” narrative. This would be consistent with other setups where favorable business conditions have been shown to be masking a mediocre business model. From current levels above historical valuation ranges and given depth of current consumer cycle it appears stock-price appreciation may be limited to earnings growth which is +LDD even under mgmt’s seemingly aggressive long-term targets.

Potential Catalysts

Disappointment vs still-elevated expectations – Negative thesis suggests the roll off of a confluence of favorable (and well-timed) company-specific and macro dynamics that came together to drive above-target performance will drive mean reversion below mgmt’s long-term targets this year. Despite the recent guide reduction continued deceleration in SSS appears likely especially since two-year SSS performance is unprecedented thereby putting management in uncharted territory. Another miss against continued bullish expectations would likely cause a swift negative reaction as legacy concerns return to the fore. Then psychological factors including the fact that the "two best years in the company's history" happened to conveniently coincide with aggressive PE/mgmt exit would likely materially weigh on sentiment.

Increasing visibility that unproven +10% annual unit growth is unsustainable – It took 30 years for the D&B concept to grow to 61 units by 2012 and it’s now expected to expand to >100 units by 2017. Any indications – driven by macro or otherwise – that this expectation is unrealistic would weigh heavily on the stock. Further indications of newbuild cannibalization and/or small-format underperformance would also likely have the Street questioning the increase in the US/Canada whitespace opp’y from 150 to 200 units.

Deceleration in SSS growth to volatile +LSD pattern – Continued deceleration points to at least a return to the volatile +2.1% pre-IPO quarterly CAGR from 2011-13 and each of those years sported at least one quarter of negative SSS. The 1H/2H 2008 precedent, recent consistent over performance and aggressive heavy insider sales that left millions on the table suggest mgmt’s visibility into SSS trends is limited.

Diminished EBITDA flow through – Unsustainability of outsized prior flow through should become visible quickly as positive impact from one-year honeymoon square footage will decline throughout 2016. Longer term the combination of a return to a more volatile comp pattern in the plus-or-minus 2% range and upward cost pressures especially on the payroll & benefits and occ’y lines should drive material variability in flow through and demonstrate that 2014-2015 and 1H 2016 flow through and margins are both unsustainable.

Heightened consumer spending/recession fears – The stock would likely rapidly decline on another growth scare such as Jan/Feb 2016 (PLAY –25% during that drawdown) or if the US experienced an actual recession especially given the already pronounced deceleration in its key top-line metrics. With the highly discretionary amusements business or “soft-core gaming” mix at an ATH 55% of revenues legacy cyclical concerns would likely pancake PLAY’s multiple in advance of any cyclical downturn in comps, non-comp revenue contribution and likely reduced unit growth. In the last recession D&B saw a cumulative SSS decline of -12.5% and one-year SSS didn’t return to growth for three years or until 2011.

Identifiable Risks

Continued financial overperformance vs LT targets – Quarterly results supportive of the bull case suggesting concept has been re-invigorated and can perform at/above mgmt’s targets off a permanently higher plateau would likely continue to drive higher stock prices. If key catalyst – a top-line miss and subsequent disappointing flowthrough – doesn’t materialize the risk increases materially that the bearish call is either too early or potentially wrong.

Continued multiple expansion – Sustained multiple expansion appears increasingly less likely especially given recent visible SSS deceleration and the fact that the current US economic recovery and equity bull market have both already reached historic duration. Thus the primary stock-price driver looks to be EBITDA growth which should – according to mgmt’s own targets – average +LDD.

Conclusion

Strong overperformance vs mgmt’s long-term targets since the company’s IPO and subsequent material stock-price outperformance has combined to create a complacent “this time is different” view regarding sustainability despite a lackluster pre-IPO fin’l history, steps taken to juice post-IPO performance including an unprecedented capital cycle, highly favorable cyclical timing and consistent heavy PE and mgmt selling. Non-consensus view suggests recent fin’l performance represents near-peak to peak performance thus eventual disappointment vs extrapolated Street estimates and subsequent sentiment hit imply asymmetric short-side risk/reward. The current setup exhibits several attractive short-side characteristics including favorable business conditions masking mediocre ROIC/FCF dynamics, extrapolated estimates, near-universal bullish sentiment, a momentum-oriented shareholder base (until recently perhaps) and heavy recent insider selling. And a shift in sentiment on any disappointment should quickly bring the company’s pedestrian long-term fin’l track record and cyclicality back into focus.

Recent 2Q print brought the beat/raise narrative to an end and highlighted fund’l cracks becoming more visible yet predictably the Street is defending. In other JOBS Act IPOs the negative dynamics often appear once PE has sold down and in this case PE is at just 6.5% and as of June no longer controls the BoD. Among other dynamics, the combination of continued historically tough two-year SSS comparisons, less-favorable non-comp honeymoon square footage mix, emergence of margin pressures and reduced positive leverage on lower SSS, shift in development emphasis away from large-format units in existing markets, materially higher maintenance and games refresh cap ex guide y/y, evidence of recent heavier promo activity including indicated heavier 4Q marketing spend, relative softness in special events segment which is seasonally key in 4Q, cont’d weak casual-dining traffic trends and the aggressiveness of insider selling points to a bearish turn in the narrative within the next couple quarters that has investors questioning just how differentiated this 30- year old concept really is after all.

It’s also worth noting a risk factor change in PLAY's 2015 10-K that has been a tell in other JOBS Act IPOs. Prior generic one-sentence risk factor "issuance of new or changed recommendations by securities analysts" became an entire paragraph including "if one or more analysts downgrade or if our results of operations do not meet their expectations our stock price could decline and such decline could be material."

DISCLAIMER:  DO NOT RELY ON THE INFORMATION SET FORTH IN THIS WRITE-UP AS THE BASIS UPON WHICH YOU MAKE AN INVESTMENT DECISION - PLEASE DO YOUR OWN WORK.  THE AUTHOR AND HIS FAMILY, FRIENDS, EMPLOYER, AND/OR FUNDS IN WHICH HE IS INVESTED MAY HOLD POSITIONS IN AND/OR TRADE, FROM TIME TO TIME, ANY OF THE SECURITIES MENTIONED IN THIS WRITE-UP.  THIS WRITE-UP DOES NOT PURPORT TO BE COMPLETE ON THE TOPICS ADDRESSED, AND THE AUTHOR TAKES NO RESPONSIBILITY TO UPDATE THIS WRITE-UP IN THE FUTURE.

Catalyst

Disappointment vs still-elevated Street expectations

Increasing visibility that unproven +10% annual unit growth is unsustainable

Cont'd deceleration in SSS growth to volatile +LSD pattern with frequent declines 

Diminished EBITDA flow through on lower SSS and margin pressures