Dave & Buster’s Entertainment, Inc. Stock Is a Buy into Earnings

Entertainment and dining company Dave & Buster’s Entertainment, Inc. (NASDAQ:PLAY) is in rally mode a day before the company releases third quarter numbers, so PLAY stock is heating up. Are investors pricing in a beat? Maybe a little bit.

But the rally has more to do with tax reform. Now that the U.S. Senate has passed a sweeping tax-reform bill, investors are starting to get excited about the prospects of the corporate tax rate getting cut from 35% to 20%.

Some stocks will benefit immensely from this reduction. PLAY is one of them. PLAY’s effective tax rate this year is expected to be about 35%. Consequently, the stock is up more than 3% in early Monday trade. Is this a rally worth buying before earnings?

I think so. Not because I think the third quarter numbers will be that good (hurricane and low NFL viewership headwinds should largely offset upbeat mall traffic tailwinds, and I’m expecting in-line numbers).

Rather, I think PLAY is materially undervalued in the long-term, especially if the corporate tax rate does come down. Earnings will draw attention to this big growth, big tax rate company, and I think there will be a lot of buying this week.

Long Term Outlook on PLAY Stock Is Favorable

The stock’s longterm outlook is quite favorable for three major reasons:

  1. The company finds itself on the winning side of a secular shift in mall retail dynamics.
  2. Huge unit expansion potential ensures strong revenue growth into the foreseeable future.
  3. It currently is undervalued considering robust earnings growth potential.

The first reason is really the heart of the bull thesis on PLAY. The company’s unique entertainment-and-dining offering leverages it to capitalize on rapidly changing brick-and-mortar retail dynamics. How? Malls are getting empty because everyone is shopping online.

This e-commerce trend is forcing malls to re-invent themselves. Malls are transforming from pure shopping destinations (which can be replicated online) into all-in-one experience destinations that include shopping alongside dining and entertainment (all of which cannot be replicated online).

Obviously, this process includes kicking out retailers and putting in businesses with differentiated, brick-and-mortar experiences.

PLAY is at the heart of this change. It is a restaurant-amusement cross-experience that cannot be replicated online. As malls redevelop to adapt to an omni-channel retail world, PLAY stores will start appearing in malls everywhere.

That brings us to the second reason to like this stock: there is tremendous unit growth potential. PLAY only has 100 stores. They are adding 15 stores this year, and expect unit growth to surpass 10% per year into the foreseeable future.

With such a small base and such a huge real estate growth opportunity in malls, it is very likely PLAY continues to grow its store base at 10% per year over the next several years. Huge unit growth potential lessens the importance of consistent comparable sales growth (which is tough to come by these days).

And that brings us to the third and final point to like PLAY stock: considering this robust growth potential, PLAY is undervalued relative to the market.

Why PLAY Stock Can Rally Another 20%

PLAY’s comparable sales growth has been decelerating (9% in 2015 to 3% in 2016 to 1.5% expected this year). But revenue growth has remained constant around 15-16%.

Why? Unit growth. PLAY keeps opening more stores. This will continue. Consequently, this is a 10% unit growth story with low single-digit positive comparable sales. That combination should lead to somewhere around 10-15% revenue growth over the next several years. Call it 12.5%.

Gross margins in the business are trending up thanks to growth in the high-margin Amusement business, but the operating expense rate is also going up thanks to higher labor costs. 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 12.5%. 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 25. A 25x multiple on $2.66 fiscal 2017 earnings implies a fair value above $66.

Bottom Line on PLAY Stock

Third quarter numbers will likely be good, but that isn’t the reason to buy this stock.

This is a 10%-plus revenue growth company with relatively stable margins and a big tax rate. That is the exact type of company you want to buy in this market with tax reform on the horizon.

All things considered, PLAY stock looks dramatically undervalued under $55.

As of this writing, Luke Lango was long PLAY. 

Article printed from InvestorPlace Media, https://investorplace.com/2017/12/play-stock-buy-earnings/.

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