Ardent Leisure Group Ltd (ASX:ALG): Follow-up Post
Post by Warwick Bagnall
This is a brief follow-up to my earlier post regarding ALG. In that post I wrote that I would write the company up in full if I found that it was robust. I didn’t find that ALG was robust but decided to summarise why anyway. Again, for the reasons mentioned in that post, I’m going to focus mostly on ALG’s chain of entertainment centres, Main Event (ME).
What I found was that there are few constraints to growth for ME to grow in the next few years. There are plenty of vacant buildings or spaces in malls which are likely to be suitable for ME stores. Unfortunately, the same can be said for Main Event’s competitor, Dave & Buster’s (NYSE:PLAY) or for any other chain or individual store which wishes to compete.
Competition is the big worry here. ME and PLAY have no customer stickiness or supplier advantages that couldn’t be replicated by a competitor. There’s little likelyhood that customers will prefer to keep visiting the same location if a competitor opens up nearby with and tries to lure them away with cheaper prices or a newer, nicer facility. I’ve been told that PLAY has better games than ME. That might help create stickiness with a small cohort of customers that are dedicated gamers but not for the majority of customers.
There is a theoretical argument that scale matters here because this is a high fixed cost business and many locations only have enough population for one site to be viable. In order to survive, a market entrant would need to take a high percentage of the existing store’s customers in order to cover their fixed costs. Because that is unlikely to happen quickly a potential entrant would decide not to enter the market.
That theory tends to work if the capex and degree of difficulty (e.g. permitting, finding competent staff) required to build a new location is high compared to the size of the company and where management of both the existing company and any potential entrants are somewhat rational. Usually I’d expect this to happen in very unsexy industries with conservative management teams. Anti-knock additive plants, galvanising works and the oilseed crush/refining industry in some locations are examples that come to mind.
In reality, the financial and emotional cost to develop a new site for ME or PLAY is low compared to the size of these two companies. Management in the entertainment industry doesn’t tend to be conservative when it comes to growth capex. I’m basing this opinion on the movie theater industry in the US and Australia. This suffered from oversupply in the 1990s, consolidated slightly in the 2000s but more recently has started to add screens on a per-capita basis. That’s in an industry where some of the players have a scale advantage in that they own both cinemas and movie distribution and can somewhat restrict distribution in order to give their cinemas an advantage over competitors. This is a good example of where the tendencies of the people in the industry are more important than the industry structure.
At a company level I can’t see much that suggests the entertainment centre industry will be different to the movie theater industry. ME has rational management at a board level – based on my opinion of the activist manager (ARA) currently in control of the board but they are intent on growing. On the other hand, PLAY has repeatedly stated that it should be able to reach its expansion targets despite competition from new entrants (presumably including ME).
My expected case is that over the next several years ME and PLAY will build out their sites, the US market will be saturated at the store counts mentioned in my initial post and ROIC will decrease to the point where the growth from adding new stores is neither value-adding nor destructive. That means there is likely to be some value created by both companies in the near future but that value creation will stop after a period of time which is much shorter than the period I would like to be able to own the stock.
My worst case is that another competitor enters the market and ME ends up being built-out at a lower number of stores than they originally predicted. If the competitor decides to enter markets ME is already in then ME’s margins will drop significantly. They may even need to close some sites.
At this stage I would normally let this idea go but the main reason for this exercise was to reverse-engineer another investor’s decision. As a non-controlling shareholder, I couldn’t decide when to sell any of ALG’s assets. Without an indication of when asset sales may occur I can’t treat ALG as a special situation. But ARA can.
If we value ALG’s theme park assets at their land value only, add in the debt, spontaneous liabilities and capitalised head office costs then I can work backwards from the current share price of around AUD 1.20 to come up with an implied valuation for ME of AUD 576 MM. If we also assume that ME’s steady-state operating margins are 15%, the value of the AUD rises to 0.75 USD and use a discount rate of 10% then that implies that ME shrinks by three stores to a total of 39. If we use PLAY’s current operating margins and the current forex rate then the implied shrinkage is even higher. In the short term there is a good chance that ALG will exceed the market expectations implied in the price.
So it looks to me like ALG is not something that ARA is going to hold for a long time. Because there is a limit on the growth of ME and because the theme park assets have little possibility of outsize growth, ARA needs to turn around ALG and exit within a few years in order to earn an outsize return. And the only way to mitigate the risk of increased competition is to be in a position to make sure that the operational turnaround is completed before ME and PLAY are likely to finish building out the remaining locations.