Take Another Taste of Dave & Buster's

Back in January, I highlighted Dave & Buster's(DAB Quote) in a column, and I chose it for one of two picks in the RealMoney All-Star Portfolio when it traded at $7.43. (If you're not a RealMoney subscriber, click here for a 30-day free trial to see all the picks in the All-Star Portfolio.)

While up a bit from that recommendation, closing Tuesday at $9.20, I think Dallas-based Dave & Buster's can still be a very big stock. It represents one of the largest positions in my portfolio! If its management can execute, this stock can trade north of $50 a share in the next few years.

Last week, I spent an evening at Dave & Buster's with some friends. Its Philadelphia facility is 70,000 square feet of decent food and good, clean fun. Its business model combines a high-quality, casual restaurant with an entertainment complex that includes electronic games, sports and carnival-type games. We had a blast! Apparently, so did many others; the place was full on a weeknight. According to local regulars at the chain's flagship, attendance has been recovering nicely since Sept. 11. My only issue with Dave & Buster's that evening revolved around the company's profitability -- or rather, the lack thereof -- based on the cash I spent there.

Heads Up on Dave & Buster's Shares could even hit $50 or more in a few years

In the fiscal year just ended, Dave & Buster's generated $350 million in revenue from around 30 high-volume stores and netted a meager $7.5 million profit. Both Dave and Buster should be ashamed at the company's 2.2% net profit margin. The company generates roughly 50% of its revenue from games, which should be an exceptionally high-profit segment. The other 50% represents food and beverages, with a high percentage of alcohol sales. Even if the food business is only modestly profitable, the combined company should be minting money!

Comparison Shopping

Dave & Buster's isn't directly comparable to any other publicly traded company, but CEC Entertainment(CEC Quote), which owns the famous Chuck E. Cheese restaurant/entertainment chain, is somewhat similar.

CEC, which trades near $50, squeezes a 17% pretax profit margin from smaller stores with a less favorable mix: lower sales per square foot, only 35% game revenue and very limited alcohol sales. Hosting birthday parties for 5-year-olds with pizza and video games can be a highly profitable endeavor!

If Dave & Buster's could achieve CEC's profit margin, the company would earn $40 million a year, or more than $3 a share. If the stock market capitalizes those profits as it does CEC's at 22 times, Dave and Buster's shares would trade up into the $60s. In my opinion, there's no fundamental reason for Dave & Buster's not to achieve similar margins or valuations to CEC's.

If Dave & Buster's fails to execute, another "sort of" comparable exists: Champps Entertainment (CMPP Quote). Champps, a sports bar chain with $150 million in revenue, has been unprofitable for most of its publicly traded history, yet it supports a price-to-sales ratio of 1.09, closing Tuesday at $12.42. Using that ratio, Dave and Buster's would trade at $30.

Pinpointing Problems

Although Dave & Buster's is certainly very cheap, some issues need reconciliation before investors value the business more fairly. Per-share earnings guidance for calendar year 2002 of 70-something cents is dismal. Clearly, better execution and profitability are absolutely necessary. The company must publish honest financial return targets, and the board of directors must hold management accountable to them. A 7% net margin, which the company earned from 1997 to 1999, should be a minimum.

Dave & Buster's also needs to generate cash. These 50,000-plus square-foot complexes have not been inexpensive, and the company's balance sheet needs some strengthening. Dave & Buster's has no analyst coverage on Wall Street and very little on Main Street. Its investor relations program could also use more management effort and resources.

I hope that the company will address these issues during its fiscal year-end conference call in late March. Right now, little information is emanating from Dallas as a new CFO acquaints himself with the business and creates a new set of financial targets. If the company doesn't generate acceptable returns for its investors, some other management team might. The big mechanical mouse of CEC is headquartered in nearby Irving.

As my readers know, I'm not too bullish on the major-cap-weighted indices. Better values can be found in the small- and mid-cap sectors of the market. I'm an absolute valuation and return investor. Ideas like the stocks picked in previous columns (with excellent results, by the way) and Dave and Buster's keep me around 70% long. This may disappoint the bears in my fan club, but you have to play to win.

I welcome any and all leads on stocks with compelling valuations and decent stories. I also welcome feedback from readers who have recently visited other Dave and Buster's outposts. (There are worse research assignments!) Remember, if Dave and Buster can execute, a little DAB will do ya!