Contrarian Investors Should Look At Drive Shack (DS)

Today I’m revisiting a company that I believe has suffered by the market more than it should. I’m talking about Drive Shack (NYSE:DS), a company operating in the leisure sector and specifically, in traditional golf and puttery venue segments. In my last article about the company, 8 months ago, I had written that a small, speculative investment in the company would make sense, as 2022 was (and is) going to be a pivotal year in the company’s growth. I also stated that the main risks were the increase in construction costs of the puttery venues. And indeed, the share price thereafter rose to touch $2/share, which stood for a 25% gain. However, the very aggressive monetary tightening policy adopted by the FED, turned the tables against leisure stocks, and even more against growing leisure stocks such as this one. Drive Shack’s share is currently trading at $0.62, with the market pricing in the uncertainty regarding the company’s path towards profitability, given the high inflationary pressures. I’m writing this article to express the reasons why I still believe that Drive Shack, especially from this price point, can provide investors with oversized returns in the near future.

Business breakdown: A cash cow and a race horse

I always liked companies that are transforming into something better, while at the same time maintaining a nice degree of business diversification. Going all – in into something new doesn’t only increase the overall risk, but also may slow the path of the company towards a profitable state. This is, fortunately, not the case here. Drive Shack has kept its traditional golf portfolio, which provides a predictable and increasing revenue stream. Currently, the company owns one golf course, while they lease and manage another 52 traditional golf courses (the AGC portfolio). Despite the decrease in walk – in revenue, the overall AGC portfolio revenue increased by 12% in Q2 2021, as compared to Q1 2022, due to the significant increase in revenues generated from special events. The reason the company owns just one traditional golf course is that they sold most of their owned courses to fund their puttery transformation, but still maintain a traditional golf segment which, in Q2 2022, was responsible for 70% of the company’s venue EBITDA and is the segment providing operating income and not a loss.

Together with the AGC portfolio, the company is taking its operations to the “entertainment golf” segment. The flagship of this segment is the “Puttery”, a very beautiful establishment where people can socialize, eat, drink and have fun playing mini – golf. However, it all started with the Drive Shack venues, which provided customers with golf – related leisure and gaming, supported by premier golf technology. Plain and simple, they’re trying to couple golf with modern day, middle class entertainment and that’s quite appealing to me. It always was, since their original business change, from Newcastle Investment Corporation.

A look into the entertainment golf segment

Since the Puttery will lead the transformation of the company towards what they call “entertainment golf” industry, I will start with that. Indeed, the putteries have the ability to change the looks of Drive Shack in a very short amount of time, due to the following reasons:

• They have a very short construction time. After land lease agreements have been signed, the Puttery development period ranges between 6 and 9 months.
• They are expected to generate $2 – $3 million of EBITDA per venue per year. This figure represents a very nice yield of 25% – 40% on cost.
• The company plans to open a total of 50 Puttery units by the end of 2024. However, supply chain disruptions, financial constraints and zoning rules could throw this plan off course. Already, two of the five Puttery units that were planned to open this year, will open in early 2023.
• Puttery revenues are quite diversified, with the majority being food and beverage, while gaming stands in the ballpark of 15% of Puttery revenue.
• Operating Puttery units show a nice EBITDA margin of 30%.

Together with the puttery, let us not forget the original Drive Shack units. These are also indoor entertainment units, which, among others, provide users with the opportunity to play golf, supported by virtual / augmented reality. These establishments are expected to generate $4 – $6 million of EBITDA per year per venue. These two parts of the entertainment golf segment, provided the company with 30% of its total EBITDA in Q2 2022.

If we take the lower ends of the EBITDA projections, for both the Puttery and Drive Shack venues, and apply an additional 20% decrease to allow for the increased inflation and its potential impact on consumer behavior, cost of goods etc., we get the following numbers for 2023:

• 18 planned Puttery units plus 2 that are beyond schedule from 2022.
• The Manhattan Drive Shack unit, which is expected to generate more EBITDA than the figures mentioned two paragraphs above. This will bring the total number of operating Drive Shack units to 5.
• Allowing for EBITDA ramp up period: Assuming 40% of the 20 Puttery units in 2023 will generate baseline EBITDA (adjusted for the 20% mentioned before). Assuming 60% for the other 30% and 40% for the remaining 30% of Puttery units. For the Manhattan Drive shack venue a baseline EBITDA rate of $8 million will be used, at a 50% discount.

From the data listed above, we can calculate a 2023 EBITDA figure of $41.6 million, for the entertainment golf segment. Let us note here that for the full year 2022, the company anticipates a total adjusted EBITDA figure of $18 million. This means that for the second half of this year, the company expects another $13.4 million of adjusted EBITDA. Assuming G&A expenses of $20 million, this stands for a FY 2022 EBITDA figure of $48.6 million, minus say $22 million of the AGC portfolio, we get an entertainment portfolio EBITDA projection of $26.6 million.

Combining the segments

I usually am quite harsh in my assumptions of my projections and that’s what I also did now. However, after all these harsh assumptions, we still get a combined $48.6 million EBITDA projection for 2023. This number includes the EBITDA generated from both the traditional golf and the entertainment golf segments. The last known enterprise value (EV) of Drive Shack is $355 million. This leads us to an EV/EBITDA ratio of 7.3x, which is lower than the industry average of 8.5x. If Drive Shack’s EV/EBITDA ratio were to reach the average, it would imply a market cap gain of $58 million, which, given the 92 million common shares outstanding, translates to $0.63 / share. In other words, from a sector EV/EBITDA perspective, Drive Shack’s shares show more than 100% upside potential, based on today’s distressed price.

Conclusions

There’s no doubt that there is a long way to profitability here and until we get there, it’s going to be bumpy. All these venues, they need money to be constructed and in this economic environment it will get ugly, in the near term. However, the company’s business model seems to be working, as EBITDA margins are significantly high and it seems that entertainment golf is claiming some of the younger generation’s purchasing power. This power is going to be reduced due to the inflation and the subsequent increase in interest rates, and that’s why this is a contrarian play. However, the company is in the process of searching the optimum expansion level. At this point, the EBITDA projections are all that I need to maintain some reasonable level of optimism for this company, again, within this deteriorating economic situation. This is a high risk / high reward option, suitable for contrarian investors.