Dave & Buster's Entertainment (NASDAQ:PLAY) is off to a fine start since going public less than two weeks ago. Its stock is doing better than the overall market, which has been wracked by volatility and wild price swings.
Although the well-known chain seems to have a lot going for it and ought to do better than the last time it was a publicly traded company (before it was taken private and then sold to Oak Hill Capital, which was behind its re-entry into the public markets), there are more than a couple of reasons investors might want to hesitate before jumping in.
On one hand are market trends that are working against the adult arcade entertainment complex, such as tough going for restaurants generally and the arcade industry in particular, and on the other there are questions about its finances that should give you pause.
Here are four more of my top concerns that would have me swearing off an investment in Dave & Buster's now.
1. It lags behind rivals' profit margins
In its IPO filings with the SEC, D&B listed 20 different companies as peers on the basis of their providing an "experience" for their customers. In addition to Chuck E. Cheese, which it's really an adult version of, and Buffalo Wild Wings (NASDAQ:BWLD), which also targets the sports crowd, but without the arcade, it includes horse racetracks (Churchill Downs), NASCAR track operators (International Speedway), restaurants (BJ's Restaurants and Red Robin), and theme-park operators (Cedar Fair).
Despite the variety of entertainment outlets, in almost all instances Dave & Buster's profit margins were below the competition.
While its gross margins substantially outpaced the competition, they fall off precipitously at the operating line and nearly vanish by the time you hit the bottom line.
2. Those gross margins are illusory
It's almost as if Dave & Buster's doesn't have any costs associated with generating its revenues, right? Gross margins exceeding 80% are something you'd expect to see in the tech industry, not in the labor-intensive and capital goods-heavy food-service industry.
And a recent MarketWatch story casts a healthy dose of skepticism on why. In short, gimmicks.
While the restaurant appropriately divides its operations into entertainment and dining for reporting purposes, and subtracts from the revenues the cost of the games it buys as well as the food and drink, it "excludes the cost of the people who make and serve the food and manage the games, as well as the cost of the buildings they work in and more. And the standard definition of gross margin doesn't."
That's how it's able to record "blended" gross margins north of 80% while Buffalo Wild Wings is at almost 24% and the industry average is somewhere in the mid- to high-20% range.
The funny thing is, D&B's "real" gross margins would fit in with those industry norms, so it calls into question why it would choose to take such an approach and suggests investors look hard at the rest of its financials.
3. It's been a loss-operating business more often than not
From 2009 through 2011, Dave & Buster's generated net losses of between $350,000 and $7 million. The company showed a profit in 2012 of $8.8 million, but that was only the product of applying tax benefits achieved from stock-based compensation deductions realized when Oak Hill acquired the company in 2010.
Now, it did record a profit of $2.17 million without such help in 2013, but over the first six months of 2014, it's gone back to its money-losing ways, even with the bennies added in, and posted a net loss of $2.42 million.
Sure, revenues are up 17% over the first six months of 2014, but that's on a 12% increase in new restaurant openings. Although the locations that have been open for a year or more did record better than 5% increases in sales -- better also than the anemic 0.5% rise realized a year ago -- that just suggests Dave & Buster's business is a lumpy one and investors will find performance a hit-or-miss affair.
4. Proceeds from the IPO paid down debt, didn't pay up for growth
The entertainment complex raised about $94 million from its IPO and is using the money to repay about $91 million of the $528 million in debt that's been eating away at its revenues.
That ought to help make it more profitable in the future, as interest payments have been pushing its operating income into the red, but while debt remains relatively cheap these days, Dave & Buster's still has over $400 million on the books.
Because it was larded with much of that debt load when it was taken private a few years back, it's been forced to serve that master instead of investing in its future.
A tough business in a tough market
Dave & Buster's is the No. 2 name in this sort of out-of-home entertainment experience, with a 32% share of the market. The leader is Chuck E. Cheese, with 43%, but as noted it's a declining industry, one that's highly competitive and must compete with theme parks, movie theaters, sporting events, other restaurants, and even casino gambling for its customers' discretionary spending.
When you add in the proliferation of and sophistication of home entertainment systems, not to mention the rise of video streaming services, Dave & Buster's will be hard-pressed to keep its growth and revenue story intact.
It was offered a $1.1 billion buyout earlier this year by Roark Capital Group, but seemingly chose instead to cash in on the popularity of restaurant IPOs from the likes of Zoe's Kitchen and Potbelly.
Do not pass go
Although investors have scooped up the IPO, it doesn't mean you should follow. Dave & Buster's is not a bad business, and in fact, it ably services a niche market. But that doesn't necessarily translate into a good investment, and this entertainment complex operator needs to show much more promise before I'd be willing to pull a seat up to the table.