Drive Shack: Business Transformation Has Low Near-Term Risk And High Long-Term Potential

| About: Drive Shack (DS)

Summary

Drive Shack will have approximately $250m of unrestricted cash after liquidation of its debt portfolio ($138m or $2.00/share net of corporate liabilities and preferred shares).

The company has an operating golf course business worth approximately $204m or $2.95/share.

The company is launching a new chain of golf entertainment venues similar to those of privately-held Topgolf.

If Drive Shack successfully builds 25 venues worth about $60m/each, then the business would be worth over $20/share.

While there is a great deal of uncertainty about Drive Shack's potential, significant insider buying hints at a favorable outlook.

Drive Shack (NYSE:DS) shares have been under pressure since the company's December announcement of its business transformation (see press release, conference call, and investor presentation). Key points:

  • Wind down of remaining debt investments

  • Conversion from a REIT to an ordinary corporation and likely cessation of dividend payments.

  • Future focus on development of a chain of golf-themed entertainment venues.

  • The first "Shack" should open for business in late 2017 and the company has identified markets for an additional 25 locations.

Regardless of the business merits of the transformation, it is likely to cause a significant turnover in the shareholder base. Yield seeking and financial sector investors are likely to sell the stock, while the company seeks new investors interested in the high growth leisure business. The return potential of the golf-themed entertainment centers is subject to many factors that are currently difficult to forecast, but purchase of $13.3mm of Drive Shack shares in December by Chairman Wesley Edens suggests that the company merits detailed study (link to 13D filing).

This article will address:

  1. Drive Shack's current valuation by segment

  2. What does Topgolf do?

  3. What is Topgolf worth?

  4. What about Drive Shack?

  5. Will Drive Shack be Successful?

Drive Shack's Current Valuation by Segment

The segment balance sheet in Drive Shack's 9/30/16 10-Q filing shows the components of the company's valuation. Note that the company has about 69mm fully diluted shares outstanding (based on treasury stock method).

  • Debt Segment ($1.81/share fair value): Company guidance is for realization of $125mm (inclusive of interest received) from liquidation of all assets and related liabilities by 06/30/17

  • Golf Segment ($2.35-$3.61/share fair value): The company uses this methodology to estimate the value of this business:

Annual EBITDA

$33-35mm

Mature business with slow growth from operational enhancements

Valuation Multiple

8-10X

Based on golf/leisure sector comps

Enterprise Value

$264mm-$350mm

Long-term debt

$102mm

Excludes other liabilities which are working capital items and $88mm of Membership Deposit Liabilities which have a 30-year term and are rarely exercised

Equity Value

$162mm-$249mm

(Source: Drive Shack, Koneko)

  • Corporate segment ($0.19/share fair value): The company has $51mm of junior subordinated notes due 2035 paying LIBOR+225 and $62mm of preferred shares. Net cash of $125mm plus $125mm from liquidation of the debt segment will put the company in a very strong financial position for development of the Drive Shack entertainment venues.

  • Drive Shack Segment ($0-$$$$/share fair value): This new business is a billion dollar opportunity whose development can probably be financed from existing equity without the need to issue any new shares. If the company is operating 25 "shacks" each worth $60mm in 5 years then the segment would be worth $21.74/share.

What does Topgolf do?

Topgolf combines a large dining/bar/entertainment center with a technology enhanced driving range. The company has 39 operating venues and plans to open 8-10 new ones each year. The promotional video on the Topgolf website suggests that the concept is extremely popular among cool professional athletes and beautiful women.

The driving range works by embedding a tiny RFID chip in each golf ball (see What is in a Top Golf Golfball? at jerrygamblin.com). Targets in the driving range are surrounded by nets that catch the balls, read the chips, and then a computer assigns a score based on the proximity of the ball's landing point to the target. See RFID Scores Well at TopGolf's Newest Entertainment Complex for more about the technology

Aerial view of Topgolf Wood Dale Topgolf Wood Dale

(source: Topgolf)

Topgolf target area

Topgolf Nets (from RFID journal)

(source: RFID Journal)

Execution of the concept has been outstanding with Topgolf sites earning extremely positive user reviews on Tripadvisor and Yelp. Advantages compared to a traditional golf course are:

  • No membership required

  • No equipment required (clubs available for free use)

  • Affordable pricing

  • No experience required

  • flexible playing time

  • available day and night

  • comfortable in most weather conditions

  • enjoyable for groups of varying ages and skills such as families

  • players can drink while they drive

  • technology enables gaming options that appeal to younger audience

This 2015 interview with COO Randy Starr provides a helpful description of the business. He mentions that 30% of revenues come from corporate and group events. He also describes aspects of what has made the business successful: marketing, social media, ambiance, quality of food and beverage, and personality of staffing.

How Profitable is Topgolf and What is Topgolf Worth?

Topgolf is privately owned, so operating details are scarce.

  • Revenues of $300mm for 2015 and $500mm for 2016 were mentioned by CEO Erik Anderson in an October interview. That implies revenue of about $15-20mm/facility.

  • EBITDA margin of 40% has been mentioned in reports available online, but I can't find an original source for this number. Dave & Buster's operates a similar business concept (food + beverage + arcade) and reported a 9M16 EBITDA margin of 30% at the store level and 26% at the corporate level (see 9/30/16 10-Q filing)

  • Topgolf currently has 39 locations with 11 more under development (LINK). Approximately one year ago, the company had 24 locations with 9 under development (LINK).

  • Average site is 65000 square feet, costs $18mm to build, and can accommodate up to 1250 people (per 2015 Golf Digest interview)

  • A per location value of $59mm can be derived from a Topgolf financing in early 2016. The company received an undisclosed amount of new funding from Providence Equity Partners and existing Topgolf investors were given an option to sell shares at a company valuation of $1.413b (disclosed by Callaway Golf (NYSE:ELY) in its 1Q16 10-Q after it sold a portion of its stake and retained 15% of Topgolf).

The location value seems to be the most useful because it is backed by public data (Callaway disclosure). It also provides some insight into the other numbers. If an average location grosses $18mm, earns a 35% margin = $6.3mm EBITDA, then each location is valued at a 9.4 multiple. If the revenue and/or margin are lower than the multiple is higher and vice versa.

What about Drive Shack?

The company has an established position in the traditional golf business (see the American Golf website for more background). Breakdown from the 2015 10-K:

The proposed expansion into Topgolf-type driving range and entertainment venues will benefit from the company's existing golf operations. The December conference call mentioned that some Drive Shack venues may be located on current American Golf properties. Existing resources of staff, land, management and market presence may provide a strong foundation for rapid development of the new venues.

Leading golf equipment maker Taylor Made is a partner in development of the Drive Shack venues (first disclosed in the 3Q15 earnings release). Note that Taylor Made competitor Callaway has been an investor in Topgolf since 2006. Taylor Made equipment will be used at Drive Shack venues and cooperation should benefit both brands. Taylor Made will not be an equity investor, so it will not pay capital costs for Drive Shack developments and will not share in net income.

Drive Shack's first "shack" is currently under construction in Orlando Florida and the company has spoken about potential for an additional 25 locations. Financial guidance has been very limited:

(source: Drive Shack presentation)

Observations:

  • The cost per site is consistent with Topgolf.

  • EBITDA guidance may be conservative. If facility revenues are $15-20mm and margin is 30%, then EBITDA/shack will be $4.5-6.0mm. Drive Shack's footnote suggested that stabilized EBITDA would be achieved within 3-5 years, but customer reviews of Topgolf facilities suggest they become very popular very quickly and Drive Shack's December conference call suggested that ramp-up time is expected to be pretty fast.

  • Valuation of 15X EBITDA is based on management estimates and hard to verify. This may be too optimistic.

  • If Drive Shack achieves operating success comparable to Topgolf, then a comparable valuation of about $60mm/shack is reasonable. EBITDA may be higher than the projection in the presentation, but the valuation multiple may be lower.

Drive Shack's site renderings suggest that the company will not be using the same netting system as Topgolf. Newer technology may be one way to quickly catch public attention. Topgolf itself may have plans to update its own technology after a 2016 acquisition (LINK)

Drive Shack - Lake Nona Orlando

(source: Drive Shack)

During the December conference call, Drive Shack explained that the concept has already been proven successful, so the company has a very aggressive development plan. Work is likely to begin on additional sites well before operations begin in Orlando.

Will Drive Shack be Successful?

The opportunity is real and at this point, nobody knows how big it is. Drive Shack is looking at the top 75 MSAs. Topgolf is talking about 100-110. Is 100 the limit? 200? 500? How many sites will the top markets support? Nobody knows yet.

Topgolf's success comes from more than just balls; they also applied brains to create a fun atmosphere. Drive Shack's potential will depend on factors that cannot be quantified in a spreadsheet. Will marketing reach the right audience? Will the food taste good? Will the interior layout and décor be appealing? Will the "shacks" be popular with cool professional athletes and beautiful young women?

With the first "shack" not opening until late 2017, investors in Drive Shack stock need to make their own subjective judgment as to whether ingredients are in place for successful development. At the same time, the near-term risk in 2017 is low because the share price is more than fully covered by net cash (after liquidation of the debt portfolio) and the value of the traditional golf business.

Disclosure: I am/we are long DS.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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