In this episode of Market Foolery, Chris Hill and David Kretzmann consider some of the latest developments at Dave & Buster's (NASDAQ:PLAY) as the company continues to defy the headwinds plaguing the restaurant industry. They also cover Fitbit's (NYSE:FIT) purchase of Pebble and why investors seem so enthusiastic about a potential tie-up between Pandora (NYSE:P) and Sirius XM (NASDAQ:SIRI).

A transcript follows the video.

This podcast was recorded on Dec. 7, 2016.

Chris Hill: It's Wednesday, December 7th. Welcome to Market Foolery, I'm Chris Hill. Joining me in studio today from Supernova and Rule Breakers, David Kretzmann. Thanks for being here.

David Kretzmann: Thank for having me, it's great to be here.

Hill: We've got some news, which is always good, because this is a business news podcast.

Kretzmann: The news fairy is very kind to us this week.

Hill: The news fairy has been on a roll lately, so shout out to the news fairy, but let's start with some earnings from Dave and Buster's. Third quarter profits were not just higher than expected, they were 79% higher than expected. They also raised guidance for the full fiscal year. I mean, this company is just crushing it right now.

Kretzmann: It's all the more impressive when you consider restaurants as a whole are having a very difficult time. You just have a handful of restaurants, and Dave and Buster's is one of them, that is still managing to attract people to the restaurants. People are still paying a good amount when they do visit the restaurants, but we've seen a lot of restaurants that have had a good run over the past few years suddenly see a decline in traffic, they're lowering guidance. When Dave and Buster's puts up results like this and raises guidance, it's understandable to see the stock pop 15% or so today.

Hill: Yeah, the stock is hitting an all-time high today, and we'll get to the evaluation in a minute, but let's go back to the point that you hit on, that this really is ... look, it's December, it is the time for anyone who does anything related to business news to start to think about what is the year-end story going to be. What are the big stories of the year. Certainly, when you look at industries as individual groups, that has been the story in 2016 for restaurants -- that there really has been a slow down, particularly in the traditional restaurant space and also the fast casual space as well.

As you said, this makes Dave and Buster's latest quarter not just all the more impressive, all the more surprising, because this is one of the most discretionary income focused stocks I can think of. When the economy is going well, then it's fair to expect a Dave and Buster's to do well, obviously they have to pull it off on the operational level, but they're doing that.

Kretzmann: Yeah, they're doing really well. It really is the amusements or the arcade and games which now makes up over half of their sales, but that's what drove the same-store sales increase of 5.9% for the quarter. You had the arcade and games and amusements sales there were up about 10%. Food and beverage sales were up less than 1%, so those games are what are bringing people into the stores, and that's where people are spending a lot of their money when they do visit a Dave and Buster's.

Hill: That's a little surprising to me. Not that the games is higher and more consequential than the food and beverage, but I would assume, and I would be wrong clearly, but I would assume that they would go hand in hand. That if you're spending more time at a Dave and Buster's playing more games, then at some point you're going to say, "Well, let's order another round of drinks, or let's order a little more food."

Kretzmann: Yeah, you would think so. Something that the company is focusing on more is exclusive games. This summer they launched an exclusive Star Trek game, they had a couple others that came out within the past few months, so those games seem to be a big draw for people. Maybe once people are in the stores they see some games, they check it out, and there's almost like a loyalty rewards factor into that. You just get hooked on the games and that will keep you coming back to the stores.

That's something that pretty much every other restaurant doesn't have, so that is a big differentiator for Dave and Buster's. I think the question is, how does this company perform when the economic situation takes a turn for the worse? On that note, restaurants I don't think have a whole lot of excuses anymore, because now the election is over. For a while people had been giving marco uncertainty as probably one of the main reasons that people were pinching pennies a little bit more, not going out, not spending money eating out.

Now that you have the election over with, unemployment just hit, what, a nine year low at 4.6%. People should be eating out and restaurants need to do a better job of attracting people to those stores. The restaurants that prove their ability to do it, whether it's Texas Roadhouse, Dave and Buster's, Starbucks, those are the ones that will continue to be rewarded by Wall street and the stock market, as they should be.

Hill: Yeah, and I'm not saying gosh, go out and pick up a few shares of Dave and Buster's because the stock's at an all-time high, but I think this is one of those times. We've seen this with retail recently too. This is one of those times where if you're an investor and you're looking at the restaurant space or you're looking at the retail space, you can sort of take a step back and look over the last, say, six months or so, and say, "Well, who has been performing?"

Because you're right, there are no excuses. I think we talked about this on an episode of Motley Fool Money recently with retailers, where you can say "No no no, it's not that consumers aren't spending. They're spending. They just might not be spending it at your shop. But they are spending." We're seeing it with restaurants too.

Kretzmann: Absolutely, and to Dave and Buster's credit on the conference call, they did credit good weather to part of their success. A lot of times companies will blame bad weather when their results aren't up to par, but it's nice to see the flip side when restaurants will give the weather a little bit of credit where it's due.

Hill: What do you think of the evaluation of this stock? Do you look at the all-time high that it's hitting today and say, "Oh boy, they're doing well on the operational level, but this is a pricey stock."

Kretzmann: When you look at the evaluation on a price to earnings basis, or PE ratio basis, the PE is now at about 27, which isn't unreasonable. It's not the highest that that evaluation has been for the company over the past year, really, since it went public. Management gave some very preliminary guidance for the next fiscal year, so next year they're expecting sales and earnings to grow in the low double digits. I think the question is how sustainable is that growth, but right now they have 88 stores opened, management sees a long term opportunity of 200 plus stores in North America. If they can continue to open those stores and put up results like this and find ways to keep customers coming back for the food and beverage and the games as well, I think there's still a long term opportunity here.

My main concern with Dave and Buster's is that they do have a fairly substantial debt load, and they're free cash flow production isn't very robust right now, because they are spending a lot of money opening these new stores, which does make sense given these results. If a recession comes, or some hard times come and the company isn't able to produce that cash and you have a lot of debt on the balance sheet, that could put the company in a tough situation.

That's longer term, the main thing I'm worried about, but I think if you're interested in Dave and Buster's maybe start with a small position and maybe follow this story and add as opportunities arise.

Hill: Earlier this week IDC, which is the global research firm, put out a report on the smart watch industry, and I'm quoting from the report here: "Smart watches will continue to struggle in the near term." Yet that did not prevent Fitbit from buying Pebble for less than $40 million. Pebble is a smart watch start up. This appears to be a move to essentially buy Pebble's platform, buy their software, buy some of their talent, some of their engineering talent. I'm not saying it's necessarily a bad purchase, and shares of Fitbit up 1, 2% today, so the stock is not being punished as a result of that, but Fitbit is in the industry that is struggling.

Fitbit previously came out and lowered guidance heading into the holidays, which has sent the stock down. Just as we look at a company spending money on a stock buy-back, and it's always fair to ask the question, "Is that the best use of your money?" I look at this and go, "Really?" You're going to spend, and we don't know the exact amount, but let's cut it in half, let's say it's $20 million. You don't have a better use for $20 million? Maybe they don't.

Kretzmann: It's a big questions right now. Obviously Fitbit is practicing what they hope will be buy low, sell high, in this case, but Fitbit is having a hard time. They're guiding for holiday sales to only really grow 5% or so, which is quite a steep deceleration of growth from what we've seen with the company since it went public last year. They do have a lot of cash to play with, they have $670 million in cash, no debt, so they're not struggling on the balance sheet right now. But they're also not producing free cash flow consistently, so we do want to keep a close eye on what is management's strategy to get out of this funk, because if you're largely a consumer electronics hardware company, as we've seen with GoPro, that it's very hard to sustain success when your revenue is largely tied to releasing new products. Earlier this year Fitbit released the Blaze, which is their first smart watch, and it did pretty well. It makes up a chunk of sale, but as we're seeing with management's guidance for the fourth quarter you need to keep coming out with new hits, and that's a very tough thing to do, especially when you're competing against the Apple watch series two, which seems to be getting good reviews and is a big step up from the first iteration of the Apple watch.

I don't know. Pebble itself has had a good amount of success on Kickstarter. That's really where the company raised the majority of it's money of the past few years. Pebble was essentially the first smart watch in 2012, but Pebble laid off 25% of it's staff earlier this year and it's not really clear what Fitbit gains from this acquisition. Maybe some help on the software side, which is where management seems to be focusing more, but I don't know. This alone certainly isn't going to turn Fitbit around.

Hill: There's a TechCrunch report that sources the price tag of this acquisition between $34 and $40 million, saying that this essentially covers Pebble's debts. If nothing else, it appears that Fitbit didn't overpay for Pebble, and so maybe that's why we're seeing the stock bump up a little as well, but this appears to be an industry that is ripe for more consolidation. Fitbit has a great brand, I think that the devices are pretty well regarded, but it really is a tough space. When you look at globally sales slowing down, which was a big part of the IDC report, and even Apple saying that year over year sales were declining for Apple. They're still selling them, but they're declining, so it's definitely a soft market right now.

Kretzmann: Definitely, and I think Apple is still certainly the top dog in this space, even with the industry as a whole facing some declines. Any given quarter, Apple still has over 50% of the smart watch market, which is pretty impressive since they came out with their first smart watch, what, I guess it was last year with the Apple watch. I worry that Fitbit and some of these other competitors are kind of in a similar position to Palm and Blackberry before the iPhone came out, where you have a known consumer brand, decent financials, or even strong financials by some measures. But man, competing against Apple is a tough thing to do and there aren't many survivors who have stood the test of time competing against Apple.

I wonder what gives Fitbit that sustainable advantage. They're trying to do more working with the software and capturing that data. People tracking their exercise, their fitness, their steps, heartbeats, all that stuff. Maybe they can package that somehow and offer more of a subscription surface, or focus more on that software side. The company really is pivoting all of a sudden to focus more on the software, and as an investor ... similar to GoPro which has tried to do the same thing and now GoPro's essentially shutting down their media component.

It's a tough thing for these companies to do, and I don't know, leaves a lot more questions to be answered for Fitbit.

Hill: Someone's having a good week, and that's Pandora. Shares up 20% in the past week. I'm trying to figure out exactly what is going on here, because this started late last week when Pandora said that they were open to talks with Sirius XM. Let me repeat that, this is not Sirius XM saying, "We're interested in Pandora." This is Pandora saying, "We're open to talks with Sirius XM. First of all, does that make sense? Because when I looked at that, Pandora being acquired by someone, I can see some entity with deep pockets looking at Pandora and saying there's value there, and we want it.

Sirius XM is kind of in the same business. I'm not sure what Sirius XM would gain from buying Pandora, and I don't know what role Oppenheimer has in all of this, but they put out a note the other day saying, "Not only do we see this making sense, we see this making sense in the range of $18 to $21 a share. Pandora is now in around $13 and a half, and that's with the 20% increase, so I thought wait a minute, this seems like a high price right now. You're saying it should go from $13 to $20, I don't know. Basically, I'm confused. I'm very very confused.

Kretzmann: I'm confused here as well. Was it this summer I think Sirius XM might have approached the board of directors at Pandora making an offer I think for $3 and a half billion or something to buy Pandora. Now Pandora over the past week has essentially said, "We're also approaching other suitors as well." I'm not sure if Pandora is what Sirius XM needs, and I don't know if Pandora can be very picky. I think at this point if you have an offer from Sirius XM for $3 and a half billion, you take it if you're Pandora.

This is a company that's lost $270 million for the past year. Really struggling competing against Apple music, Google, and YouTube Music, Spotify, Amazon. You're competing against some very big players here, and Pandora is still very dependent on advertising to generate the bulk of it's revenue. Whereas you see Apply Music, Spotify, Amazon really shifting to approach where it's a subscription business. You pay $7 to $10 a month and you can essentially listen to anything you want to. It's not some algorithm deciding what you can or can't listen to.

That just seems like a much more attractive model for consumers, and Pandora's trying to pivot more toward that, but the company's still very tied to advertising. I don't know, Pandora's in a tough situation and the company's certainly not making money right now, so if you have an offer from Sirius XM, I don't know if it necessarily makes sense for Sirius, but it certainly seems to be an attractive offer for Pandora.

Hill: I mentioned this to Bill Barker the other day, and I said, "What does Sirius XM see in Pandora?" He very quickly said, "Well, they probably see themselves." If you think back to when Sirius was a stand-alone satellite radio, and XM was a stand-alone satellite radio company. They were both sort of 1990's versions of Pandora. It's like, "Oh yeah, we've got all this music and we're losing money hand over fist." I don't know, it'll be interesting to see if they actually do get together. I can't imagine there would be any sort of regulatory issues here.

Kretzmann: I don't think so, because Sirius is really tied up with Satellite radio, Pandora is online streaming. Sirius has tried to do a little bit more with having its own mobile app and stuff, and getting more into that streaming space, but certainly the company is still very tied to satellite radio. I think that the problem with Pandora is when you're competing against Apple, Google, Amazon, those company's music services are part of a larger ecosystem, but Pandora, how exactly do you differentiate yourself in that space?

I think that could be another space where if you're not part of that larger ecosystem you're going to see some consolidation. I think maybe a merger with Spotify might make more sense, because it's just harder to make a different product from other companies that are offering the same music that you are. Maybe your algorithm is a little different if people are listening, or maybe we move into exclusive music for some of these providers, but Pandora's in a tough situation right now.

Hill: Part of what had me thinking about regulatory approval is while you and I are in the studio right now, across the Potomac River executives from AT&T and Time Warner are meeting with the nice people on Capitol Hill to talk about their proposed merger, and their fervent hope that it gets approval. Much bigger merger, many more dollars and consumers involved there, so we'll see if that one actually happens.

Kretzmann: That's where the regulators are focused.

Hill: Yeah exactly. If you're a regulator you're like, "How much money is involved in the Pandora? Yeah, that's fine. Here's the rubber stamp, we'll just stamp that, that's good."

Kretzmann: Wrapping up with music, as you know, as long time listeners know, producer Dan Boyd and I like to take time in December to expose our listeners to holiday music beyond what they get on the radio, because it's just the same 50 songs over and over. So as we will be doing all month, we're going to wrap up today with Washington D.C.'s own Chuck Brown. Thank for being here man.

Hill: Thanks for having me.

Kretzmann: As always, people on the program may have interest in the stocks they talk about on Motley Fool may have formal recommendations for or against so don't buy or sell stocks based solely on what you hear.

Hill: That's going to do it for this edition of Market Foolery, this show is mixed by Dan Boyd. I'm Chris Hill, thanks for listening, we'll see you tomorrow.

Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool’s board of directors. Chris Hill owns shares of Amazon.com and Starbucks. David Kretzmann owns shares of Amazon.com, GoPro, Sirius XM Radio, Starbucks, and Texas Roadhouse. The Motley Fool owns shares of and recommends Alphabet (A shares), Alphabet (C shares), Amazon.com, Apple, Fitbit, GoPro, Pandora Media, Starbucks, and Texas Roadhouse. The Motley Fool has the following options: long January 2018 $90 calls on Apple, short January 2018 $95 calls on Apple, short January 2019 $12 calls on GoPro, and long January 2019 $12 puts on GoPro. The Motley Fool recommends Dave and Buster's Entertainment and Time Warner. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.