Dave and Buster’s (PLAY) Initiate at “2”

Today we are initiating coverage of dining and entertainment chain Dave and Buster’s (PLAY) with a neutral “2” rating. From a fundamental prospective we like the company’s unique business model in a crowded dining and entertainment sector, but the shares have rallied sharply from the high 40’s to the high 50’s since their last quarterly earnings report, which gives us pause due to what now appears to be a full and fair valuation. Should the stock decline, we would be looking to upgrade at an attractive price (around the $48 level or so), given PLAY’s market positioning and current growth trajectory.

We have not covered PLAY in the past, due mainly to the fact that more than 50% of revenue (>57% in 2018) comes from games and entertainment, as opposed to food and beverage (>42% in 2018). However, given our shrinking coverage universe (due to continued M&A activity), we are expanding our reach and feel PLAY fits nicely into the theme of consumer entertainment experiences. Just as a night home streaming Netflix and ordering in can provide a more than satisfying consumer experience, we believe PLAY locations offer a similar balance of food, beverage, and fun.

Very quietly, PLAY has grown at roughly 10% annually in recent years, doubling its location base from 61 in 2012 to 121 at year-end 2018. Such growth is poised to continue, as the company sees an eventual market opportunity of 230 units in the U.S. and Canada alone. PLAY is also testing out different box sizes for its locations, as traditional mall locations in big cities are getting saturated. A smaller location in medium sized cities can still bring something new and exciting to the area, along with strong returns on capital.

We like how PLAY stacks up in two core areas; unit economics and further growth potential, whereas valuation is fair given the recent share price appreciation (~20% in recent weeks).

First, PLAY is earning EBITDA margins in excess of 20%, well above that of traditional restaurant chains. This is due to a higher markup on food and beverage (much like the cinema sector, but not as egregious), as well as strong pricing power given the selection of gaming options within their locations. Due to the self-service nature of much of the gaming offerings, labor costs also run lower (sub-25%) on a unit-level basis. We like the strong unit economics, which resembles the movie theater model, but unlike the movie space, PLAY should be able to create an environment that is harder to emulate at home, which is AMC’s challenge with Netflix, etc.

Second, we see no reason PLAY cannot continue to grow units 10% annually, given they are relatively small (121 locations vs thousands of movie theaters, for instance). With more than 350 million people living in the U.S. and Canada, PLAY can double its location base and still only have one for every 1.5 million residents, which is far from market saturation. The company could reach that size by opening 15 locations per year for the next 8 years.

Lastly, with regards to the valuation of the stock and the ability of them to grow the business within current cash flow, we find the current price full and fair. We estimate that PLAY’s existing unit base generates roughly $180M-$200M in free cash flow. Construction costs are being supplemented by impressive tenant allowances offered by landlords ($40-$50M annually), which allows PLAY to grow without issuing more debt or equity. In fact, the company actually generates roughly 5% of revenue in free cash flow each year, after accounting for new location buildout costs. This allows them to repay debt and repurchase shares, to create more shareholder value than unit growth alone would provide. Leverage is reasonable at less than 1.5x annual EBITDA today, so stock buybacks should continue.

At the current price of $58 per share, PLAY trades for about 12x our estimate of existing unit free cash flow ($2.2 billion equity value against $180-200M of FCF), as well as around 9x EV/EBITDA, slightly above the dining sector average. Given that PLAY offers more growth potential, higher margins, and less competition, on average, relative to traditional restaurant chains, we would be attracted to the stock if we could get it for 8x EV/EBITDA, or around $48-$50. The reason we are being a bit picky here is because the company does tend to locate units near large shopping centers, and enclosed malls are seeing traffic pressures. We think their non-traditional model of games and food will set them apart from many dining establishments, but at the same time we don’t expect the company to maintain a premium valuation consistently due to mall traffic concerns among investors. As such, we think it is a good play (pun intended) but only at the right price.

As a result, we like the risk/reward of PLAY in the high 40’s but a recent rally to $58 puts our initial rating at “2.” We would peg fair value in the $60-$65 per share range based on current financial projections, and will upgrade accordingly should the stock price fall back in the near to intermediate term. Quarterly earnings have tended to be unpredictable and more volatile compared with peers (our guess is due to less guest frequency given higher spend per visit versus traditional restaurants), so it is quite reasonable to expect there will be attractive opportunities to take a more constructive view of the shares in the future.