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Dave & Buster’s stock has become a bit of a “battleground” over the last six months, since operating results have not been as impressive as over the last several years when the Company was consistently meeting and beating expectations. Investors can judge for themselves the relative merits of the bull and bear case and whether the stock, now in the low 40s, down from about 70 a year ago, adequately discounts the uncertainties.

The Positives:

  • (1) Cash on cash returns are still attractive, even if overstated by non-inclusion of pre-opening expenses, which have been increasing.
  • (2) There is a very long runway for future growth, which has been extended by virtue of the new 17K format.
  • (3) The balance sheet continues to be strong, relatively unleveraged, with substantial liquidity from operating cash flow and borrowing power, to fund unit expansion, stock repurchase, and dividends possible as well.
  • (4) There is potential for improvement in the Food & Beverage segment, including a Fast Casual approach to be tested in ’18.
  • (5) The potential for a “blockbuster” amusement offering exists, including the virtual reality platform currently in development, which could spark a new round of same store sales growth.

The Negatives:

  • (1) Comps have been coming down, narrowing overall, with a continuation movement toward Amusements, now 56.9% of revenues. With less than 30% of sales from food, D&B is more of an amusement park than a restaurant.
  • (2) Average Unit Volumes are coming down, at least partially due to the increasing mix of smaller stores.
  • 3) Margins at the store level have been coming down modestly, and may not recover due to higher marketing, higher rents, higher commodity prices, and sluggish traffic trends, especially within the food & beverage segment.
  • 4) Competition, and cannibalization is playing an increasing role in suppressing sales and margins.
  • (5) Depreciation, that is the useful life of Amusements, continues to be an underlying issue. EBITDA is a valid measure of “cash on cash” return at the store level, but it seems to require increasing amounts of original (undepreciated) capital as the years go on.  No one can be sure of the useful life of Amusements. The Company declares that it is “between five and twenty years”. We discuss this issue at more length later in this article. We have not seen this issued addressed in either company documents or analyst discussions. If our concerns are misguided, we welcome further discussion of this issue by the company or the money management community.
  • (6) Insider selling, and relatively small stock ownership by top management is a continuous feature of this situation. The largest shareholder among executives is CEO, Stephen King, who “controls” only 1.1% of the O/S shares, about 77% of which are through options. Numerous executives, including King, have immediately sold stock after exercising options.

PLAY: Company Overview

Source of Revenues

Dave & Buster’s Entertainment, Inc. is the Dallas-based owner and operator of 106 dining and amusement venues in North America as of July 2017.  The company aims for a distinctive experience with stores designed to “Eat Drink Play and WatchAll Under One Roof.”  In what we refer as “2017”, which is the 53 week ending 1/31/18, its stores generated revenues of $1.14B, of which “amusements and other” (“A&O”) sales contributed 56.6% of revenues, food and beverage sales contributing the balance. The A&O portion of revenues has grown steadily in recent years. Redemption games represented 75.7% of A&O revenues in 2017. Video and simulation games, many of which can be played by multiple players, represented 21.5% of A&O revenues, up from 17% in 2016.  The remainder of the games are “traditional”, such as billiards. A&O offerings have very low variable costs, producing a gross margin of 89.3% in 2017, so contribute a much higher than proportionate share of corporate gross margin.

Eat Drink Play Watch

D&B’s refers to its menu as “Fun American New Gourmet”.  It features classic casual dining entrees and appetizers ranging from choice-grade steaks, gourmet pastas, and premium sandwiches to snacks, health-conscious options and less healthy desserts.  Menu items are presented with a flamboyant “fun twist,” and served in dining areas adjacent to the “Midway“ games and “D&B Sports” large screen viewing areas.  Each location features a full-service bar and beverage service throughout the amusement areas.  The beverages range from a variety of beers and traditional cocktails and spirits to novelty items such as “Luxe Patron LITs”, “Smash tails” and “Glow Kone’s.”  Both the food and beverage offerings are updated with new items three times each year.  Food (including non-alcoholic beverages) comprised 67.9% of food and beverage revenues (29.5% of total revenues) in 2017, while alcoholic beverages accounted for 32.1% of food and beverage revenues (13.9% of total revenues).

The Midway section of D&B locations typically offers over 150 games designed to create a high energy social experience. Almost 80% of amusement revenues are derived from games in which customers can win prizes ranging from branded novelties to high-end electronic items (redeemable in a retail-like “Win!” booth). The company aims to keep its games fresh, including offering some of the latest high-tech games commercially available.

The D&B Sports section of the stores are designed to provide customers with an immersive environment for watching live sports and other televised events.  Stores typically have 40 large screen TV’s with high quality sound systems, including a 100” HD set. The D&B Sports venue is relatively new feature of the D&B experience, having been included in remodels and new stores since 2010.

Company Strategy

D&B has been a public company twice, the first from 1997 to 2006, when it foundered following some operational missteps, including an ill-advised acquisition. It was taken private and operated by several private equity entities until October 2014 when it was re-launched as a public company.   Stephen King, the current CEO, has lead D&B since 2006, during which time many of the elements of the company’s strategy were put into place.  Possibly chief among them has been the expansion of the higher margin amusements category to its 56.6% of revenues (in calendar 2017, up from the previous level of only 44%.  A second key initiative has been the extensive remodeling of its stores, transforming them throughout as a vivid statement of its Eat Drink Play Watch promise.  With the remodeling program substantially complete, the company has stepped up new store growth from 2 stores in 2011 to 11 stores in 2016, 14 in 2017, and 14-15 in 2018.

The company’s customer mix is young adults (~54% male), families (household income $75K+), tourists and corporate & social special events (~10% revenues).  About 3.5% of revenues are spent on marketing and the promotional initiatives to target these demographics. Messaging aims to build awareness of D&B as the “best place to watch sports” or “the only place to watch the games and play the games,” and otherwise reinforce its multivariate Eat Drink Play Watch offerings that complement each other in a way that cannot be replicated at home.  Further, many promotional initiatives (such as “Eat & Play Combo”) offer discounts to drive a value positioning.

D&B envisions the potential for about 230 stores in North America, including the new 15-20,000 sq ft (“17K format”), with over 57% of new units in existing markets and the remainder in new markets.  Internationally, the company is pursuing franchise and joint venture opportunities and has signed a licensing agreement for 7 locations in the Middle East.  It expects the first store under the agreement to open in Dubai in 2018.

Long term the company targets 10% annual store growth and comps of about 2%, though guidance is for negative LSD comps in ’18.  At this level of revenue growth it expects that leverage of G&A and marketing expense will result in low double digit EBITDA growth over the long term.

Unit Level Economics

D&B stores are deployed in a large and small format, depending on the market and site availability.  The smaller stores range from 25K to 30K square feet with target year 1 revenues of $8.7M, while the larger stores range from 30K+ to 45K square feet, with target year 1 revenues of $10-12.2M. The newest 17K version is targeting $4.5-5.0M in year 1. The potential number of stores suggested by third party research is over 230 in the US and Canada, including the current locations. The new 17K version should allow entry into smaller markets, the first of which opened recently in Rogers, Arkansas. It is expected that 20% of future stores will be the 17K version, with the balance split between the other two formats.

The development costs net of landlord allowances and pre-opening expense is $6.8M and $8.3-8.8M for small and large stores, respectively, and less than $5M for the new 17k version.  In their first year, the company targets store-level EBITDA margins of about 29%, a cash-on-cash returns at 35% for both the large and small format stores, and a 5-year average cash-on-cash return greater than 25%. It is worth noting that, per the 2017 10k, the 48 stores opened since the beginning of 2008, opened for a full year as of 2/1/18, have generated an average year one return of 49.6%. The forty stores opened after fiscal 2010 have generated 53.5% C/C in year one.  However, the 5-year target is provided because the D&B stores typically enjoy a particularly strong year 1 honeymoon, generating cash-on-cash returns of 40%-50%, well in excess of targets, as demonstrated by the above disclosure. Predictably, the lower AUVs in years 2 and beyond (down 10-20% in year 2) have lower margins as well. However, since overall store level margins have been steadily rising, hitting a peak of 30.8% of sales in 2017, virtually flat from 2016, it appears that the margin declines in year two and three of younger stores may not be weighing as heavily on overall margins as the stated model implies. All the returns quoted above do not include the investment in pre-opening expenses, currently running about $1.5M per location, obviously reducing the above stated returns materially. The stated returns are also before depreciation & amortization of leasehold improvements and it remains an open question as to how much should be “reserved” to refresh the critical A&O segment, as discussed below.

Operating Metrics

The company has made enormous strides under the 12 years of Mr. King’s leadership.  Net income has grown over $130M to $91M in 2017 up from prior losses of $10M, while EBITDA margins have increased by over 1,200 bps.  Comps have been consistently positive (though slowing recently) since the IPO, averaging over 5%, driven to a great extent by games.  In the same period, restaurant-level EBITDA margins have increased 420 bps to 30.8%, while company EBIT margins have increased 460 bps to 14.5% in 2017 (down 50 bps from 2016) from 9.9% in 2014.

A hardly discussed metric relates to the critical A&O segment. D&B’s model relies on maintaining customer interest with relevant and fresh games.  As such the company’s projected 5-20 year useful life of its games (per its depreciation schedule) can be questioned.  Even a 5-year life, the lower end of the range, seems questionable in an age when mobile phones are replaced every 2-3 years.  If so, a more rapid replace/refresh pace would necessitate an increase in annual games investment, reducing free cash flows.  On the other hand, a replacement rate at the current pace or slower risks a decline in game productivity. Indeed, an inappropriately long game replace/refresh rate contributed to the company’s troubles in its previous foray as a public entity. The vulnerability of this portion of revenues was demonstrated recently, in Q4’17 when an unexpectedly difficult comparison to last year’s more dynamic game offerings affected results negatively.

The Depreciation Issue – Further

Nobody can be sure of the useful life of Amusements. The Company declares that it is “between five and twenty years”. The last time PLAY was public, ending 2006, the useful life was considered five years. Today the Company does not provide the periodic depreciation amounts on the Amusement portion alone, so we cannot determine the average useful life that is assumed today. However, the gross investment (before depreciation) in games is provided and it seems like the productivity of those games is consistently declining, just as in 2000-2006. For example, at 1/31/12 the investment in “Games” was $60.9M and generated $310M of A&O revenues in the following 12 months, or $5.08 per undepreciated balance sheet Games Asset. This “return on investment” has declined each year to $4.00 (from $5.08) for the FY ending 1/31/17 and $3.74 in the FY ending 1/31/18.  As previously stated, the same pattern prevailed in the 6 years prior to going private in 2006 as the “ROI” declined from $2.52 to $2.12. Though old D&B’s games operated at a much lower level of productivity, the steady progression of deterioration is the same. There may be other causes for these patterns than declining sales productivity, but lacking better insight, game asset turnover seems an important metric to monitor. Of course, the Company’s overall Return on Invested Capital has increased in recent years, even while the return on Amusement Investment has apparently declined. This is no doubt a function of the very high profitability of Amusements and the large amount of capital that has been poured into this segment (including store renovations), outweighing the 26.4% (from $5.08 to $3.74) smaller “return per dollar invested” over the last five years. However, on a much larger base, a continued decline in the productivity of existing investment, even if new Games are successful, could affect total results more materially.

We have not seen this issued addressed in either company documents or analyst discussions. It’s entirely possible that our concerns are misguided, so we would welcome further discussion of this issue by either the company or the money management community.

Balance Sheet Considerations

In the 2 years ending 12/16 the company aggressively paid down $165.3M of legacy debt incurred prior to the IPO, but the long term debt increased by $95M in 2017, paying for the stock repurchased as described below.  As of the end of 2017 its ratio of long term debt to TTM EBITDA was a modest 1.4X. In 2017 the company generated an operating FCF margin of $44M or 3.9% of sales (Net Cash Provided by Operating Activities of $264M less $220M of Capex). The $152M spent on stock repurchase was financed by the increase in long term debt of $95M, the $44M of operating cash flow, and working capital changes.

Shareholder Returns

Since the IPO in October’14 at $16.00, the stock has appreciated by 162%. The company does not pay a dividend but in 2016 spent $38.8M, and $152M in 2017 repurchasing common shares.

Recent Developments – Per Q4’17 Report and Conference Call on 4/3/18

It is hard to say that that Q4 results were anything but disappointing to both the investment community and the company. Earnings per share met Street estimates, but only with the benefit of a 10.6% tax rate versus 36.7% a year ago. Overall comp sales were down 5.9%, vs. +3.2% a year ago. Comps in Amusements & Other were down 4.2%, Food & Beverage was down 7.8%, Walk-in sales were down 6.4%, Special Events were down 2.9%. Considering the sales trends, the still impressive store level EBITDA margin of 30.9% was well controlled, down from 32.3%. Five stores were opened in Q4, in Tampa, FL: in Woodbridge, NJ: Auburn, WA: Baltimore, MD: and Bayamon, PR, fourteen openings for the full year.

Guidance for calendar ’18 was adjusted downward in terms of total revenues, with a negative comp of low to mid single digits, net income of $95-110M (vs.$121M in 2017), after an effective tax rate of 23-24% (vs.22.7%) and EBITDA of $255-275M (vs.Adjusted EBITDA of $303M). 14-15 openings are planned, 8 stores in new markets, 11 large format, 2 small, and 2 @ 17K. Note that calendar ’18 is a 52 week year, vs. 53 weeks in ’17. Part of the possibly conservative outlook is the indication given that the first quarter of ’18 has started off slowly.

Per the conference call:

Management indicated that the big surprise in Q4’7 was the slowdown in A&O revenues, getting worse through the quarter and continuing in ’18. The comparison with a year earlier “Rock ‘em, Sock ‘em” turned out to be a problem. Directionally, the biggest factors were “number one, content: number two was weather: number three was increase in competitive intrusion”.  A&O revenues grew as a percentage of total revenues in Q4 by 110 bps to 54.5%, continuing the long term trend away from Food & Beverage.  The 2018 game lineup provides high hope, including a proprietary virtual reality platform being developed in conjunction with a “very well known Hollywood film franchise”. As of 4/3, it is “currently being written. We have the agreement for the IP so we’re confident we are going to deliver it in midyear, but exact timing is something that we’ll wait until we have a 100% line of sight”. In terms of pricing the offering: “we have priced VR in cash as a separate item…without the ability to utilize it on your Power Card. …..we tested it at $5 per person….we may offer some promotional ways… but our thought is that we put it out at $5 per person and kind of see what demand it generates”.

On the food and beverage side, an intensified effort is being made. There was discussion that Eat & Play Combo (“EPC”) is “not resonating with the guests as well as they once were”, so a new version is being tested. Also, the Happy Hour offering “isn’t resonating quite as well” so that is being restructured as well. A new VP of Food and Beverage Development has been hired. New burgers have recently been introduced, with chicken and steak to follow. Speed of service is being emphasized, with ordering kiosks being deployed, and a Fast Casual approach will be tested in H2’18.

Management reiterated how profitable the store model is, saying that the 2016 class generated first year C/C returns of more than 50%. (That is store level EBITDA compared to net cash investment, not including pre-opening expense.) As discussed above, under our “operating metrics” section, pre-opening expense for the year, no doubt affected by the timing of openings, was $23.5M, or over $1.5M per store with 14-15 locations opening per year, that is obviously a more than material increment over the stated “net cash investment” per store of $6.8M and $8.6M per small and large store respectively.  It was pointed out that the higher labor at new stores, combining with higher occupancy expenses, higher marketing and the generally higher wage rate contributed to the margin deterioration YTY. During Q4, depreciation was lower by 140 bps (a “sensitive” subject, relative to our discussion of depreciation above), G&A expenses decreased by 60 bps, pre-opening expenses were up 110 bps (which relates to our discussion of $1.5M/store, above). Corporate EBITDA was up by 4.3%, down 190 bps as a % of sales to a still admirable 23.2%.

Conclusion: Stated at the Beginning of this Article