Description

Buy DS’s 9 ¾ perpetual preferred for an 11.4% current yield.

While the current Covid-19 destruction has caused carnage among many sectors, in our opinion, it’s been fairly market efficient in crushing the travel/tourism/levered-cyclicals segments where it could impair earnings pretty significantly given quarantine effects and leverage among so many of these businesses where missing a single year’s worth of earnings can be catastrophic (given insolvency risk from leverage) even if the virus isn’t a threat nine months from now.

However, we think one pocket of opportunity lies in the Drive Shack 9 ¾ perpetual preferred equity, selling for $21.33 – an 11.43% current yield! Please see my last writeup on the DS equity from 3/2019 along with pat110’s from 4/2017 for background information. The thesis hasn’t changed much except for some updates on box size and their new minigolf concept.

We think the stock got hit last week (especially on Friday) given the overall Covid-19 drop in experiential entertainment (in a quarantine scenario, no one’s going out to swing borrowed golf clubs others have sweat on just before you) which was exacerbated by a CFO resignation with the earnings release on Friday. We believe algos hit the preferred (and the equity) based on looking for weakness in experiential entertainment from Covid, a big drop in cash levels yoy (based on building new locations) along with the CFO resignation. Because the preferred is far less liquid, though more secure than the equity, it got hit about as much on Friday.

CFO resignation – we think it wasn’t a huge issue in that it will take awhile for the company to build their locations and grow (hence significant opex cuts recently), while the financial operations/balance sheet of a business like this is fairly simple so, promoting their Chief Accounting Officer to interim CFO (and possibly permanent) isn’t a step down in controls, especially since he was a Managing Director at Fortress before taking the DriveShack job.

Fortress affiliation – as discussed in my previous writeup, the predecessor company to DS was/is controlled by Fortress with Wes Edens as Chairman. From speaking to folks at Fortress, we know this is a business he helped create, is excited about, has built out the management team and will not let go bankrupt even in the most dire COVID scenarios (which we believe won’t come true).

CEO – the CEO, Hana Khouri, was Director of Operations at TopGolf for about four years and worked as Director of Operations for LiveNation before that. Our checks from the Liberty folks are positive on her. She took over from Ken May whom she worked for at TopGolf after he resigned for health reasons. During her non-compete, she worked for New Fortress Energy for over a year, essentially a one-year long interview working for Fortress.

Again, please see my previous writeup for a comprehensive overview of the business. My 2023 consolidated EBITDA number is not too different from what the company guided to on their Q4 2020 earnings call on Friday so I’m not really changing my outer year numbers on earnings, debt burden (though this should come down) and free cash flow but will highlight some of the near-term positives manifesting in the bull case playing out, along with the addition of their mini-golf concept.

In my previous writeup, I’d said: DriveShack estimates about $30m to build a new location with an 18-month period to hit steady state revenues of about $20-25m and a 30% EBITDA margin. We estimate maintenance capex in the several hundred $k level, thereafter, thus a very good ROIC, again, assuming the concept isn’t a fad.

From the Q4 2019 press release, the company said: The new venues have ramped up faster than anticipated and are expected to achieve EBITDA margins of approximately 25% and development yields of 10 to 15% in 2020.

The ramp up is happening along the lines of our target with four locations open and ramping to 25-30% EBITDA margins. However, we had expected another five to be opened in 2020 but the company has only one committed for 2020, New Orleans as they scaled back to ensure they can achieve their profitability targets in every new location.

That said, they introduced a new mini-golf concept, UrbanBox. For UrbanBox, they expect $7-11m in development costs, $7-11m in revenue, $2-3m in EBITDA and 25-35% development yields. They also expect to have 50+ locations open by the end of 2023, along with 8 DriveShack locations, resulting in $165m in EBITDA by 2023.

The higher development yields and lower capital intensity of the UrbanBox stores means lower debt levels though, clearly, potentially lower barriers to entry. That said, no one has really recreated the Dave & Busters concept, nationally.

While an overview of the business is helpful in understanding ROIs and long-term free cash flow, for the preferreds to recover, the salient points are a bit different.

Covid-19 related effects to liquidity: Assuming Covid-19 results in a nationwide quarantine from schools, entertainment venues…etc, what does DS’s solvency and ability to pay out the preferreds look like? Assuming absolutely no revenue, the cash burn is clearly high. Recurring OCF (ex new launches), in 2019 was about $20m with $38m in cash on the balance sheet. Backing out fixed costs for the 4 DS locations, at steady state margins and 50% of opex being variable, we think the incremental cash burn from operating the DS locations without any revenue is an incremental $2m. It’s so low because they just opened these locations so they’ve been running them at losses, so far. On the managed services golf courses, while the profits and losses flow through the income statement, these are fixed managed services agreements with about $8m in annual FCFs that would go away, assuming no one playing in a mass quarantine (though you can’t get COVID-19 outside!!).

All in, if the company operated with no revenue but didn’t cut out fixed opex, they’d burn at about $25-30m for a year, depleting just about all their cash. In reality, should this worst case scenario come through, I doubt Fortress or Wes Edens will let the company go, in which case we’d probably see some sort of dilutive equity offering that might kill equity upside but it’s hard for me to see the preferred get totally impaired in a worst case COVID-19 scenario.

In a more realistic bear case, we see 3-5 months of burn with little revenue, maybe $10-15m, for which the company has ample cash and insurance payment proceeds. In this scenario, we also likely see a pause on new development construction which maybe pushes out the 2023 EBITDA targets/bull case.

I wanted to get this out right after the big drop on Friday 3/6 but will continue to update the board as I get more color on the company’s COVID plan of action, insurance proceeds and other sources of cash to keep the business going in the worst case scenario.

As far as terms of the preferreds – you can read through the original prospectus from 2003 but it’s a plain vanilla perpetual preferred, junior to the debt, senior to the equity, no voting, quarterly dividends…etc.

Catalyst

COVID-19 fears abate, the company discusses its strategy for maintaining solvency through different risk scenarios, Fortress/Wes Edens come out supporting the stock.