Does Dave & Buster's Best-in-Class Status Make It a Buy?

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In this consumer and retail segment, Jeremy Bowman offers his take on Dave & Buster's (NASDAQ: PLAY). Combining the food and beverage business model with amusements, the company has outperformed the broad restaurant industry for several years running. However, even this leading industry-leading company is beginning to show signs of wavering in the face of significant headwinds, both in the restaurant sector and across the retail world.

Find out whether this best-in-class business has a place in your portfolio. 

A full transcript follows the video.

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This video was recorded on Oct. 17, 2017.

Jeremy Bowman: My name is Jeremy Bowman. I'm a consumer goods analyst with The Motley Fool. I cover mostly retail, restaurants, and e-commerce, and some other consumer-facing stocks. The retail and restaurants sector has certainly been tough lately as e-commerce is upending traditional traffic patterns, and malls and shopping centers and restaurants seem to be suffering from over-expansion in recent years. And a number of fast casual concepts IPO-ed. But one stock in the restaurant space that I think has the potential to be a big winner is Dave & Buster's. And now looks like an excellent time to buy. Shares have pulled back recently, losing about a third of their value over the last four months.

Dave & Buster's is unique in the restaurant industry, because in addition to offering food and beverages, the company attracts customers with amusements like arcade games, billiards, and even bowling. This not only gives the company a unique customer proposition but also a competitive advantage, as that entertainment segment provides an additional revenue stream and a more valuable one as amusements are a higher margin business than food and beverage.

The company had 100 locations in North America as of its most recent earnings report, and they see room in the market to double that to at least 200. Comparable sales at the chain have beaten the casual dining benchmark for 21 quarters in a row, which is another sign of its competitive advantage and the attractiveness of its business model. As mall vacancies open up, I also think landlords will look to Dave & Buster's to fill empty spaces as a traffic driver, and the company should be able to get some excellent lease terms as retail dynamics shift.

Perhaps most importantly, Dave & Buster's has beaten earnings estimates in every one of its quarterly reports since it went public in 2014. That's a sign that Wall Street continues to underestimate the stock, and that gives it a little bar to jump over, especially as its price to earnings valuation has fall into just 20x, on par with slower-growing peers like Darden, Cracker Barrel, and Buffalo Wild Wings.

Shares plunged after its last earnings report as investors were scared off by modest comparable sales growth of just 1.1% and a decline in food and beverage comparable sales. However, it's likely that that's just a blip, and one quarter's worth of comparable sales is not a good reason to sell, as that figure is usually volatile. Even as the broader restaurant industry struggled, I think Dave & Buster's games give it a special draw that should keep customers coming through the door and profits growing.

The overall business looks solid. The growth path is clear, and the valuation is the lowest that it's ever been for the stock. I think now is a great time to buy.

Shen: I've briefly talked about Dave & Buster's on the show previously, and I'll admit that I'm slightly biased here in that I have an inherent respect for this company, because they've essentially managed to create a Chuck-E-Cheese for adults. And I think there's something kind of awesome about that. Their amusement business is, I feel like, the real power engine behind this company. What are some of your initial thoughts on this one?

Douglass: First off, one of my great regrets is that I've never been to a Dave & Buster's. Maybe we can arrange an office visit or something, purely for research purposes, of course. [laughs]

Shen: That would be awesome. That sounds like a good time.

Douglass: That sounds like a great Friday afternoon. We'll see if we can sell it on up. A couple of things that I saw. Comp sales beating benchmarks for 21 quarters in a row, when you see that sort of consistent outperformance, that's a great sign. And I think it really speaks to the fact that Dave & Buster's is in, frankly, a weird niche. You have your entertainment, you have your game watching, and you have your game playing, and you have your food and your drink. And that's just such an interesting combination and experience, it's hard for me to see folks leaving that, because I think it's such an unique experience. When we talk about restaurants, often talking about TGI Fridays versus Ruby Tuesday versus a Red Robin or whoever, and it's hard to tell a huge difference between them, because they're offering fundamentally similar products in a lot of cases. Dave & Buster's is just different.

Shen: And we see how that has an impact on their financials as well, in that the amusements side of the business, I think it has a slight majority of their top line, around 55% to 57% of their revenue. But the gross margins there are absolutely astounding. I think they're approaching, if not just 1% away or so from 90% margin in that side of the business. That's also driving a lot of their comparable sales gains. You've mentioned how, was it 21 quarters, these comps are very strong. But at the same time, we've seen a deceleration. I think that's why they've been dinged so badly over the summer. The latest quarter, I think it was 1.1% for their comparable sales growth, and investors did not like that.

Douglass: And I'll say, it reminded me, I'm flashing back to Whole Foods a year or two ago when they first started reporting that comp sales were seriously decelerating. And I was, at the time, an unrepentant Whole Foods bull. I said, "Sure, but the new stores are doing really well. And yeah, things are moderating, but they're still positive," and then they just kept going down and turned negative, and that's when I started seeing my thesis really fall apart. I'm not saying Dave & Buster's is there. But I do want to warn people against becoming complacent with, "Well, it's still positive, they're still beating the category." Because of course, the restaurant category as a whole, it's kind of had a tough year so far. So one of the things to consider as well is, whether the overall headwinds for the industry make even what might be one of the better or even the best in class companies in it still worth an investment right now.

Shen: Yeah, I think that's a really good way to look at it. I think there have been some, industry research firms put, for the second quarter, comps across the restaurant industry down something like 1% to 2%. So that 1.1% looking pretty bright, relatively. And we talked a little bit about, who do you compare this company to in terms of its peers? It isn't like those quick service restaurants and traditional operations. Could they even be compared to the gaming industry? But when it comes down to it, just because it's so strong if you put it in that restaurant sector, doesn't mean that it's the best place to put your money. I will say, though, again, ending on a valuation note, when I checked it this morning, they were trading at about 17x their forward earnings estimates.

Douglass: Which really isn't that bad.

Shen: Yes, very reasonable for this sector as well.

Douglass: And that puts you pretty close to the S&P, within a couple of points in either direction.

Shen: Sure. And the long-term growth estimates from analysts are not too far from that. So looking at it from that kind of perspective, I don't want to say this is one that I've really disagreed with Jeremy on the thesis. Like I said, I do think this is one of the best in class, and I love this business. But investors, you do need to consider, is the restaurant sector where you want to be putting your money right now?

Jeremy Bowman owns shares of Dave & Buster's Entertainment. Michael Douglass has no position in any of the stocks mentioned. Vincent Shen has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Buffalo Wild Wings. The Motley Fool recommends Dave & Buster's Entertainment. The Motley Fool has a disclosure policy.