Dave & Buster’s Entertainment Inc (NASDAQ:PLAY) recently reported its third-quarter earnings. Although the results were mixed — earnings beat but revenues missed expectations — PLAY stock is up solidly.
Comparable sales limped in at a 1.3% decline, versus a 1.1% rise last quarter and a 3.3% rise last year. Margins were pressured by rising operating costs. The revenue guide was cut, but the profit guide was largely maintained.
Given the numbers were so mixed, why is PLAY stock up more than 5%?
PLAY was a $73 stock back in June; it was a $53 stock heading into the Q3 report. That near-30% decline in a few months set the stock up nicely for a big post-earnings move. PLAY stock had entered a massive valuation trough, going from 30x earnings to 20x earnings.
Thus, when Dave & Buster’s reported decent results that showed 9% revenue growth and 16% earnings growth, investors bought back into the beaten up PLAY growth narrative.
Does this rally have legs? Can PLAY stock head even higher?
I think so. The whole reason you buy PLAY stock is for its tremendous unit growth potential, which just got a big boost thanks to the roll-out of smaller format stores. With the unit growth trajectory now more promising than ever, PLAY stock looks good.
The ugly truth about Dave & Buster’s is that comps are in free fall. Two years ago, comparable sales were up 9%. Last year, they were up more than 3%. This year, they are expected to be up about 0.4%.
Clearly, the era of super-charged comparable sales growth is over for PLAY.
But that doesn’t mean the growth narrative is over for PLAY stock.
Revenues are still expected to rise about 15% this year due to 15% unit growth. This robust unit growth should continue because PLAY only has about 100 locations, which is an exceptionally small number for the restaurant industry.
Moreover, as malls continue to adapt to omni-channel retail by transforming from pure shopping destinations (which can be replicated online) into all-in-one experience destinations that include dining and entertainment (all of which cannot be replicated online), PLAY stores will start appearing in malls everywhere.
It also helps that PLAY management realizes unit growth is the key to its growth trajectory. The company is introducing smaller-format stores, which should extend unit growth potential.
With such a promising unit growth trajectory, the PLAY growth narrative doesn’t need super-charged comparable sales growth to drive big revenue gains. Roughly 10% unit growth per year on flat to low single-digit comparable sales growth should drive somewhere between 10% to 12.5% revenue growth. Call it 11.25%.
Gross margins in the business continued to trend up in the quarter thanks to growth in the high-margin Amusement business. But the operating expense rate is up slightly more. Store operating income margins compressed 20 basis points, while EBITDA margins were flat. Over time, opex deleveraging will likely more than offset gross margin improvement, so net profit margins should fall.
But share buybacks should largely offset the effect of that margin compression on earnings growth. Consequently, earnings growth over the next several years should match revenue growth, or 11.25%. Given PLAY is a full tax-payer, PLAY stock should trade at a similar growth premium to the S&P 500 .
The S&P 500 is trading at a 100% premium to its growth potential (20x 2017 earnings for ~10% growth). Apply that same premium to PLAY stock. You get a “fair” 2017 earnings multiple of 22.5. A 22.5x multiple on $2.66 fiscal 2017 earnings implies a fair value of just under $60.
Given the company’s tremendous unit growth potential and huge tax rate, I’m a buyer of PLAY stock below $60.
The quarter wasn’t great, but it’s good enough to illustrate that this growth stock is undervalued. I expect this new uptrend in PLAY stock to continue.
As of this writing, Luke Lango was long PLAY.