Dave & Buster's: Increasing Downside Risk (Ratings Downgrade)

Summary

• Q3 financial performance has largely been a disappointment.
• Valuation appears reasonable, but there are no catalysts for major stock price appreciation.
• Macroeconomic risks remain elevated and pose major downside risk to Dave & Buster's stock.

R_Type/iStock via Getty Images

Ratings Downgrade

We initiated coverage of Dave & Buster's (NASDAQ:PLAY) on August 24, 2022, with a hold rating. Our rating then was largely based on the company's post-pandemic rebound in its financial performance and attractive valuation as well as macroeconomic risks. Since then, the stock has remained at the same level as during the time of our coverage. However, given the disappointing Q3 earnings and impending recession risks, we are downgrading our rating to a "SELL" as we believe the company's stock price will likely underperform in the short to medium term.

Q3 Earnings Recap

Though management reported strong topline growth metrics (largely driven by the acquisition of Main Event in June), we were concerned about the decline in profitability as the company wrangles with cost pressures. The company reported a quarterly net profit of $1.9 million compared to $10.6 million the year before. The YoY decline in quarterly profit has been concerning given the relative strong U.S. consumer demand in that quarter along with a deteriorating balance sheet. As seen below, the company's quarterly long-term debt has seen a substantial rise since the acquisition of Main Event and its cash balance remains similar to historic levels. The overall bottom line hasn't given us enough evidence of the strength of the company's business operations, and makes us more pessimistic about its medium-term prospects.

Data by YCharts

Macroeconomic Risks

Since the time of our initial coverage, a lot has changed in inflation and interest rate expectations, along with the likelihood of a U.S. consumer recession. The base case scenario appears to be an economic slowdown and a recession this year, with risk of deeper recession if inflation persists more than anticipated and the Federal Reserve raises rates even more. As consumers spend less, Dave & Buster's is likely to feel a major impact on its bottom line and stock price performance. This is because Dave & Buster's operates in the intersection of entertainment and restaurant business, both of which are highly leveraged toward U.S. consumers and operate in a discretionary segment. Furthermore, the company caters predominantly toward middle-class families. As unemployment rises and families have less to spend on discretionary services and products, spending on entertainment and restaurant food will be the first budget to be slashed. Dave & Buster's will likely have to compete by slashing prices and providing more promotions, which will hurt their bottom line and growth opportunities. Given that the company is still integrating its Main Event acquisition along with plans to grow its international presence in the Middle East, we find that there could be additional execution and strategic risks if the economy were to go more sour than anticipated.

Short-Term Valuation Peak

The company has largely rallied from its October 2022 lows, and the company currently trades at around 15.47x forward P/E. Compared to top restaurant chains like McDonald's (MCD), Dave & Buster's has a low P/E ratio. However, as mentioned in our initial coverage article, we believe the lower relative valuation is warranted due to its major exposure to cyclical risk and weaker fundamentals than a traditional fast food chain. On a short-term basis, the valuation is at the upper range of its last 6 months' trading range, which has ranged from 11x to 16x forward P/E. We believe that given the economic headwinds and worse-than-anticipated Q3 results, the valuation multiple could contract in the short term as investors flee away from this cyclical stock. At the very least, we would be more comfortable with the stock at around 12x P/E ratio which would be at the lower range of its near-term valuation history.

Data by YCharts

Conclusion

We are revising our rating from a "hold" to a "sell" for Dave & Buster's stock. The company has seen its bottom line contract YoY as its liabilities increase as a result of the acquisition of last year. Given the likely scenario of a recession in the U.S. economy, we believe there's too much risk in this stock at the current valuation, which is in the higher range of its near-term valuation history. We believe that investors can find better opportunities that are safer and provide better shareholder value in the form of dividends in other stocks.

Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.