Dueling Fools

Dueling Fools

Dave & Busted
Bear Argument

By Bill Barker (TMF Max)
October 6, 1999

If you liked Rainforest Cafe (Nasdaq: RAIN) and Planet Hollywood (delisted) as investment experiences, you're going to love Dave & Buster's (NYSE: DAB). Start with the kind of "awesomely outrageous" deep-fry fare served at any TGI Friday's, Bennigan's, or Uncle Moe's Family Feedbag, toss in a collection of video games that allow you to pretend to be jet-skiing without having to put your beer down, find some real expensive real estate to put it all in, and you've got the Dave & Buster's experience. As a business model, it certainly works for virtually anyone who's between the ages of 21-30, though not so well for anyone else -- which explains why it is now reporting slowing same-store sales, the death knell metric for any high-volume restaurant chain.

A typical bull argument for Dave & Buster's might go something like this: When the recent news came out that same-store sales were down 2.2% and Dave & Buster's was hammered for half of its market cap, the market was simply overreacting. After all, here's a company that has been increasing sales and increasing earnings, and it still has estimated long-term earnings growth of about 25% and a trailing P/E of about 11. Hey, the perfect Fool Ratio stock!

To that, I say... "Ha."

Taking an income statement approach to this company and focusing on earnings just won't get you anywhere, or if it does get you somewhere, it's to the wrong place. You have to look at the balance sheet to get a real feel for why the earnings, even if they are growing (more on that later) don't really mean anything.

Warren Buffett would describe this as perhaps the prototypical company to avoid. In his 1992 Annual Report to Shareholders, Buffett wrote, "Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return. The worst business to own is one that must, or will, do the opposite -- that is, consistently employ ever-greater amounts of capital at very low rates of return." Simply put, under this analysis, Dave & Buster's qualifies as one of the worst businesses to own.

Dave & Buster's has been growing its earnings, and analysts today currently expect Dave & Buster's to keep growing earnings. That much is true. But here's the catch -- they aren't the kind of earnings that anybody would want. The company isn't growing earnings by reinvesting large amounts of excess cash from operations, but instead is relying on things like secondary offerings and debt issuance to find the money to build new units. These units, in turn, produce a return on equity or return on assets or return on invested capital that is truly uninspiring.

Take a look at the historical numbers for Dave & Buster's return on assets for its last four fiscal years:

1996: 3.8%
1997: 6.3%
1998: 5.6%
1999: 6.3%
And those numbers are higher than what the company is currently producing after its FY2000 second-quarter blowup. That's just not good at all. The story with this company, which now has $70 million in long-term debt, is that the cost of capital for this growth, whether issuing debt or equity, is higher than the returns on the invested capital. Essentially the company is a value-destroyer, transferring wealth from its shareholders to its employees, customers, suppliers, and management.

But, look, even if for some reason you do subscribe to the theory that earnings growth, regardless of how that "growth" is financed, really matters, the earnings for this company are probably about to stop growing and go into deep decline anyway. For the most recent quarter, earnings are down from a year before, and earnings next quarter are also expected to be down over the year before. And there is, by the way, no special excuse that the company has to pin that decline on except poor business execution.

Nevertheless, even though the company is already established in the better markets and locations in the country, it is going to keep putting up more units in more and more marginal spots -- ones that have to have lower and lower returns on invested capital than the existing units. So the company will continue to pile on debt to expand in a way that detracts from whatever uniqueness the existing locations have had, further impacting same-store sales and hurting the unit economics. The cost of labor continues to go up for all restaurants as well, and Dave & Buster's has no pricing power that I'm aware of to raise prices on its run-of-the-mill fare -- so margins are almost unquestionably going to suffer.

Maybe my friend Rick sees something to like, but I'm just going to put him on the spot here anyway. My introduction to The Motley Fool several years ago actually came about as I was researching this very company. In the process I found some message on one of the old AOL boards, circa 1995-96, from one MF Edible about Dave & Buster's. At the time, he said he liked it, but he liked Rainforest Cafe more. I agree with him -- these are similar companies.

Be afraid. Be very afraid.

Next: The Bull Responds