Description

Dave & Busters (ticker: “PLAY”; “D&B”) is the leading entertainment and dining venue with over 100 locations and tremendous unit, revenue, and margin growth since coming public in late 2014. D&B has the only scaled and unique "Eat/Drink/Play/Watch" positioning that combines food service, alcohol, a full sports bar, and a comprehensive gaming experience. Their value proposition is unique and memorable. With only 105 stores (compared with BWLD at 1240, TXRH at 517, EAT at 1660, and BLMN at 1515), I also feel it is underpenetrated. 

Recently, however, D&B has been down 40% off its highs since pre-announcing a dismal -5% SSS comp in January. The concerns have been building, given their slowing SSS comp and 18 months of negative Food/Bev sales per store. They are trading at valuations >1 stdev below their 5 year average, and at a 30-35% discount to their average relative to the S&P (1.5 stdev).  Clearly investors are having “broken model” concerns, questioning whether their “Eat/Drink/Play/Watch” strategy is suffering from increased competitive intensity or waning interest from millennials. Both issues would apply pressure on their industry leading margins. 

I believe D&B’s recent struggles are not structural, but rather temporary or fixable issues related to food service execution, gaming content, and consumer out-of-home food spending. Demand for “experiential services” is large and growing, and their multi-generational appeal enables them to continue building scale and leverage Virtual Reality gaming as a traffic driver for resuming Same Store Sales (SSS) growth in 2h18. 

I believe they can continue their unit growth (9-13% per annum) and resume low-single-digit SSS for the next several years. While I expect that increasing gaming investment and marketing spend will slightly impact their four-wall margins, scale will mitigate the enterprise impact (believe margins will settle in at 14.5%, off their peak in FY16 of 15%, but still strong). Including the tax benefit, I forecast EPS of $3.74 in FY19 and $4.25 in FY20.  

Yesterday, Raymond James put out a note indicating Dave & Buster’s likelihood of pursuing a sale is higher after Hill Path Capital’s recently reported a 3% stake.  Hill Path has ties to P/E (Scott Ross was a former partner at Apollo Global, which acquired CEC Entertainment in early 2014) and involvement in other public entertainment/consumer companies, including SeaWorld, Rent-A-Center, and Club Corp.

The Raymond James analyst noted PLAY has "significant FCF power," which under “no growth” scenario would result in 2019 after-tax FCF return on equity of ~10%.  Their LBO analysis assumes an acquisition price of $57.50/share, for total of $2.75b, including ~$350m of net debt, equating to an EV/EBITDA of ~10x 2018 and 9x 2019, below recent transaction multiples in the space (Roark acquired BWLD for ~10x; Darden acquired Cheddar’s for 10.4x; Del Frisco’s recently acquired Barteca for >10x).  Notably, PLAY has been taken private twice before: in 12/2005 by WellSpring Capital) and in 6/2010 by Oak Hill Capital Partners.

Short interest is ~16.5% of the float and the short interest ratio is ~8.7x.  Directors has actively purchased stock in the open market at current levels within the past six months.  PLAY reports Q1 on June 11.

RECENT SSS PROBLEMS ARE FIXABLE

Channel checks, including store visits and discussions with former executives / competitors confirm that the food & beverage weakness exhibited over the past 18 months was the primary cause of recent traffic issues undermining SSS trends.   This distinction is crucial, as it specifically rules out more serious problems that could be structural in nature, including, (i) demand for entertainment experiences is waning, (ii) competition is stealing share (more on this below), (iii) D&B’s gaming / amusement offerings are getting stale or had benefited from unsustainable drivers in the past or (iv) D&B Sports (what they call “Watch” and was a major store renovation in the 2013 to 2015 timeframe) was losing its core 20-40 year old demographic.

D&B management realizes service levels have been an issue and is aggressively addressing the problem. In 2017, they implemented a Table Management System in 2017 which allows them to get the data necessary to improve the experience and optimize staffing. In addition, in early 2Q17 D&B introduced handheld devices that enable customers to pay at their tables. This is still being rolled out across the organization.    Management has also described introducing “service enhancements” within the restaurant portion of PLAY’s operations, which are in the process of being implemented. We expect benefits from these efforts to start flowing through in the next several quarters.

Moreover, food quality problems are being addressed with a similar sense of urgency.  Management’s explanation is the menu was designed for marketing on TV, and resulted in food and drink offerings that were often tried out of curiosity, but were rarely repeat purchases. Examples include Adult Glow Cone drinks, Coronarita’s (mixed Corona with Margarita), Carnivore Pizzadilla (pizza and quesadilla), Pepperoni Pretzel Pull-Apart, and many other mash-up choices.   These offerings were complex from a kitchen perspective, and hard to deliver consistently. The company quietly released their VP of Food & Beverage in January, validating their commitment to a new direction.  D&B also has a broad full-service menu, quite large when compared to other casual dining peers. This has also contributed to quality and execution issues.  I have confirmed that PLAY is placing a greater focus expanding its food and beverage attachment rate by adjusting its menu options, and is testing more “fast casual” type offerings through this year.  

Importantly, competition does not appear to have been a driver of their SSS slow down.  Conference calls confirm that no competitors are directly competing with D&B at scale. The largest direct competitor, Main Event, has 40 locations and is “in turmoil” and “has stalled out”.  If competition were limiting their opportunity, it would have been felt in the productivity of new store openings. D&B targets year one cash-on-cash return of at least 35% for both its large and small format locations, but the company continues to exceed this target significantly. Stores built after FY08 are generating a 47% average Year One cash-on-cash return and stores built after FY10 are generating a 52% average return.

Despite SSS issues, I have confirmed that new locations are not underperforming the corporate average, and CCs think the development function within D&B is world class. As such, I expect low double digit growth in square footage to continue through FY20.  D&B management has guided to 215 total units for the total TAM. The recently announced smaller footprint store is expected to add an additional 10-20% locations, and CCs believe this is “very conservative” with the new format being a “home run”.  D&B has solid visibility into its new store development pipeline as management has signed leases several years into the future.  D&B is positioned to capitalize on the closing of some big box retailers as these retailers rationalize unit footprints amid deteriorating trends/unit economics and shifting retail shopping habits to online.

SSS compares ease every quarter sequentially throughout 2018 (on a 2-year and especially 3-year stacked basis). The fourth quarter was really cold in their core markets, and provided a headwind beyond the issues mentioned above. As you get past that to more suitable weather and a better content roll-out, expectations should be exceeded.

That said, given D&B’s remarkable returns from new stores, I believe the system’s same-store sales performance could range from -5% to +5% and have no impact positively or negatively on the company’s unit growth story.  D&B’s generation of over 50% cash-on-cash returns is unheard of within the U.S. casual dining sector, driven primarily by differentiated and high-margin entertainment offering. Even within the overall restaurant sector, there are only a select few publicly-traded quick-service chains generating returns either near or over 50% (Domino’s, Wingstop, Shake Shack).

D&B suggests advertising spend has become less effective, and this is a result of general trends within Cable TV viewership, particularly in their target audience. This is not complicated to adjust, and they have already moved toward increased social media and online advertising in 2018.

D&B had very difficult gaming comps in 2h16 of +6.7% which led to a difficult 2h17. This was based on several new product launches which were hard to lap, however, recent management commentary confirm that gaming is still quite healthy and that the D&B team in this area is top notch. There is little concern that they will continue delivering new content that excites the customer: management believes the rollout of virtual reality (VR) games across the store base this summer could help drive traffic, as the virtual reality platform can run multiple types of content, while the introduction of new content comes at a comparatively lower cost than its other gaming platforms. D&B will emphasize the introduction of additional exclusive gaming systems and highlight the differentiated offerings on national ads in the coming quarters. Having tested VR over the past four years, the technology has matured to the extent that this could be a significant traffic driver, particularly given the maturity of higher end VR systems and the lack of penetration at home.

PRIMARY RISKS / MITIGANTS

Same store sales growth continues to weigh on growth in 1H18, furthering pressuring sentiment.  D&B’s significantly larger average store size in comparison to its restaurant peers places them at greater profit risk in the event traffic continues to be an issue, thus impacting its best-in-class margin profile.

It is unclear whether upcoming results will demonstrate a reversal in recent poor SSS trends. However, I believe that I am being paid to take this risk, as D&B is currently trading as cheaply as the worst casual diner (that has low/no growth prospects), despite having an industry leading return and margin profile.

That said, I believe D&B’s margins are sustainable for the following reasons:

Alcoholic beverages account for one-third of food and beverage revenue which is roughly double industry average. When combined with amusement revenue, over 70% of D&B’s revenues earn 85%+ gross margins.

They have the lowest food and labor cost versus peers, thus the highest restaurant contributions margins.  D&B is far less exposed to typically volatile food input costs at only ~8% of the company’s total sales in comparison to 25-30%+ of total sales on average for its major restaurant peers.

The potential evolution of its dining business toward limited service could represent both sales and margin opportunities over time (e.g., more on-trend, less customer friction, faster service times, less labor intensive) and is not priced into the stock.

VALUATION AND TARGET PRICES

My base target price is $70 (still below recent highs), conservatively based on 19x FY19 and 16.5x FY20 estimates. On and EV/EBIT basis, 13x FY20 numbers are well below the market average. This is a 60% opportunity over the next two years that I believe gets catalyzed with SSS turn around later in 2018.

Disclaimer:

This report is for information purpose only and does not serve as investment advice.

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

Better execution, rollout of virtual reality leading to recovery in SSS growth in 2H 2018.  Potential takeover target it stock remains at these levels.