Bowlero Corp
Levered in Every Way
9/16/24
Company - Bowlero Corp.
Ticker – BOWL
Stock Price - $11.89
Market Cap - $1.8B
EV - $4.57B
Summary
Bowlero (BOWL) presents a compelling short opportunity driven by a risky roll-up strategy in an industry facing structural decline. The company's heavy reliance on debt, high fixed costs, and misalignment between management compensation incentives and shareholder interests raise significant concerns. As bowling's popularity wanes and management continues its aggressive expansion, the company is poorly positioned to sustain its growth strategy. The market is overlooking these risks, creating a clear downside opportunity. My 3-year price target of $4.20 represents 65% downside.
Background
Bowlero is a De-Spac formed in 2021, one of the few that are not well below their IPO/Cash Shell price. Bowlero's pitch to investors is a Private Equity LBO (leverage buy-out) roll-up strategy, acquiring bowling alleys (and new builds), renovating, and improving operations. Accounting games, high operating and financial leverage, dying sport, lofty valuation, and a high bar set for FY2025 (Fiscal year is July-June) make this an interesting short candidate. For those that follow me on X - @OSA_Rochester, you know how critical of management I've been who knowingly touting financial results that do not tell the true underlying picture.
Side note – My childhood revolved around bowling. I started bowling when I was 5 years old and bowled into college. I also worked at a bowling alley for ~3 years.
Model - The unit economics of bowling alleys are relatively easy to model. Price x (games bowled/person) x customers represents revenue from bowling revenue. Factor in F&B (Food & Beverage) and arcade games, and that's roughly 100% of revenue.
Business Description
Bowlero is the largest operator of bowling centers, with 352 bowling centers across North America (Primarily US) under the Lucky Strike, Bowlero, and AMF brands. In addition, they own the PBA (Professional Bowlers Association). Revenue classification: 1. Bowling revenue (49% of FY24 Revenue) — League bowling, retail bowling, and shoe rentals. 2. Food and beverage (35% of FY24 revenue) 3. Amusement revenue (15% of FY24 revenue)— Revenue generated from arcades and other games. 4. Media revenue (2% of FY24 revenue)— From sanctioning official PBA tournaments and licensing media content to customers, including television networks and multi-year contracts. Bowlero's FY ends at the end of July. Fiscal Q2 and Q3 are seasonally the strongest quarters (winter).
The bowling alley industry is highly fragmented, with most centers owned by mom-and-pop, leaving room for future acquisitions. Bowlero has grown from 291 in Q1 21 centers to 352 in FY24. In 2023, Lucky Strike Lanes (14 centers) was acquired for $90m. According to IBIS World, there were 2,701 Bowling Center's in the US as of 2023, a decline of 3% from 2022. With just 350 of the 2,700 alleys (down from 5,000+ in 1998), Bowlero has a long runway to consolidate the industry. The decline in bowling popularity caused many centers to go out of business. In addition, the bowling center business is capital-intensive, with many older centers becoming outdated.
I witnessed firsthand the decline in popularity (even though management believes it's growing), resulting in alley closures. When I began bowling in a junior league on Saturday morning, the league occupied all 52 lanes. Every year, the league got smaller and smaller. When I left in 2012, the league took up 20-26 lanes. In 11 years, the league was half of what it was. While working at the alley, adult leagues, which once had waiting lists and double shifts (one league at 6 pm and another at 9 pm), now struggle to fill one shift on Friday and Saturday. Leagues are an essential part of the business for Monday-Thursday when recreational bowling is far less than Friday, Saturday, and Sunday. Another headwind is the continued rise in the popularity of the NFL. The bowling season goes head to head with the NFL season; Sundays are likely less full than decades ago as people prefer to watch the games instead of bowling.
The retail/leisure side remains a popular activity. According to management, the average customer bowls 1.5 times yearly and 2.2 games per visit. Two games were the average amount, as one game wasn't enough; however, three games either took too long or bored people. It's unlikely the number of games bowled will move a material amount one way or another. Bowling is seasonal, with popularity peaking in the winter and dying in the summer. The decline in bowling alleys over the past 20+ years goes hand in hand with the decline in popularity. The decline in popularity is permanent and a significant headwind for Bowlero. Will bowling ever die? No. I believe bowling alleys are likely to group in highly populated regions. The issue again is not that Thursday, Friday, and Saturday are slow; it's Sunday-Wednesdays. The operating model is almost an entirely fixed cost structure.
EBITDA – A Terrible Proxy for Cash Flow, Yet Management's Focus
***Note that my definition of EBITDA and the companies differ. My definition of EBITDA is Net Income + Taxes + Debt Interest Expense + PP&E D&A
Management's focus on earnings calls, presentations, and bonuses is EBITDA performance and, at times, using EBITDAR (Earnings before Interest, Taxes, D&A, and Rent). Bowlero leases 340 of the 352 centers, doing so under both operating and capital leases. Excluding rent removes one of the company's most significant annual expenses at ~$240m. Accounting standards treat capital leases like debt, with the expenses flowing primarily through the interest expense line and partially through D&A, while COGS includes operating lease expenses. EBITDA excludes a ~$94m yearly capital lease expenses required to operate the centers.
In addition to excluding capital/financing lease interest expense, Bowlero currently has $1.15B of variable-rate debt with a current rate of ~8.6%, SOFR + 350bps. A 1% increase/decrease in rates results in a +/—$11.5 m change to interest expense. With interest rates expected to come down, Bowlero will see lower interest expenses, a tailwind given the high financial leverage.
Bowling centers are not capital-light businesses, especially the business model Bowlero operates. One acquisition strategy is to purchase legacy outdated bowling centers and transform them into premier entertainment centers. On their recent Q4 earnings call, they stated, "In Miami, the new one at Beverly Hills we're about to open, Tysons Corner, any of these that we've built new. I mean, it's almost like Vegas in your community. That level of glitz and glamor. So you put it all together, and we've got a winning model." Ongoing costs are required to maintain these centers. D&A should average 9-10% of revenues. Once again, excluding this real cost is misleading at best. In FY24, D&A related to PP&E was ~$121m.
The total REAL expenses excluded from EBITDA are $66.4m from capital leases, $28.3m from Financing obligation interest, $100m in interest, and $120.8m in D&A, totaling $315.5m. On a total expense base of $1,171m, EBITDA excludes ~27% of expenses. Put simply, EBITDA is not a good proxy for FCF for the business. Due to NOL carryforwards, the differential is greater on a fully taxed basis.
High Operating + Financial Leverage – Good on the way up…
A change in the tax code post-2022 affects Bowlero in how Adjusted Taxable Income (ATI) is calculated to deduct interest expense. Starting in 2022, depreciation, amortization, and depletion are no longer added back to taxable income in the calculation of ATI. This generally results in a lower ATI, limiting the interest expense deductible under the 30% cap (businesses are limited in how much interest expense they can deduct each year—generally capped at 30% of the company's adjusted taxable income). The high-interest expense relative to their ATI means Bowlero cannot use the total interest expense as a tax deduction. Using EBIT as a proxy for ATI, EBIT of $51.4m results in ~$17m of deductible interest expense for tax purposes, even though the debt interest expense was $100m. Under the previous tax regulation, EBITDA was the proxy for ATI, which would have increased ATI's taxable income by $120m, increasing the allowable interest expense deduction by $34m. As of June 30, 2024, they had US tax credit carryforwards of $9.1m, US federal net operating loss carryforwards (NOLs) of $175.9m, US state NOLs carryforwards of $55.6m and interest carryforward of $185.2. They wrote off a significant portion of federal NOLs in 2023, as the federal NOL balance was $460m at the end of 2022. The remaining federal NOLs will begin expiring in 2027. Other NOLs expire yearly, while Interest Expense NOLs do not expire.
Deleveraging the business would be a net benefit. Lowering the interest expense would allow the company to utilize the interest carryforward. Since the business is already overleveraged, reducing balance sheet risk and increasing free cash flow while keeping cash tax payments the same for the foreseeable future seems prudent.
As stated before, Bowlero has $1.15B of variable rate debt at 8.1%. I also discussed how Bowlero leases most centers. Leasing brings on contractual obligations from yearly lease expenses. While some argue that leases are a weaker form of debt, under this business model, I view leases and debt as the same.
From the FY2024 10-K, " Payments under our non-cancelable, long-term operating leases account for a significant portion of our operating expenses, and we expect many of the new locations we open in the future will also be leased. We often cannot cancel these leases without substantial economic penalty. If an existing or future location is not profitable, and we decide to close it, we may nonetheless be committed to perform our obligations under the applicable lease, including, among other things, paying the rent for the remainder of the lease term."
If these leases were short-term or able to be canceled, the risk would be minimal; however, this is not the case. "The Company has three master lease agreements with Carlyle covering over 200 locations. Two of those master leases contain initial terms ending in 2047 with 8 renewal options for 10 years each. The third master lease contains an initial term ending in 2044 with 8 renewal options for 10 years each." They also have a master lease with VICI for 38 locations. These are NNN leases with annual escalators at the greater of 2% or CPI with a 2.5% ceiling. In a declining business, having long-duration, non-cancellable leases seems incredibly risky.
High fixed-cost business, with long-term non-cancelable leases (increasing fixed costs) and high leverage (more fixed costs), in a declining industry results in significant stress in weaker economic environments. It's a fragile business, where a minor slowdown could result in considerable stress. Given their appetite for growth through debt, a slower, internally funded growth model is not something they are interested in, as they recently increased their revolver capacity to increase M & A activity.
Another area I struggle to understand is the pivot toward new-build bowling centers. Given how many have closed, it's surprising that areas of the country are missing centers. Bobby Lavens tweeted several locations where they are building centers, and while the population of these cities has grown, it's surprising that there are economically viable new-build centers or that there aren’t existing centers in these areas that could be acquired and remodeled for cheaper.
Management – Little Trust & Accounting Games
A risk I see is the desire to build a bowling empire, regardless of the economics. Founder Thomas Shannon controls Bowlero through the 100% ownership of Class B shares, which entitle him to 10 votes per share. Mr. Shannon controls 85.2% of voting rights. In the 2024 Proxy Statement filed on 10/27/23, Mr. Shannon owned 3.656m class A shares (2.3m from converting Class B to Class A shares – he can't sell class B shares since they aren't publicly traded, and 1.356m shares stem from stock options vesting in the near term). No member of management has purchased the stock since the IPO; they've only sold it. (Yes – Lavens & Bass technically purchased stock, but it was from reinvesting the dividend paid on September 6)
Management's short-term compensation is based on EBITDA, which, as noted above, is not a good proxy for the business, given the delta between EBITDA and Net Income.
Delving deeper into this, understand how backward the incentives are compared to what's best for shareholders. Remember above when I discussed the Interest Carry Forward and how tax regulations changed in 2022? Management is incentivized to sign as many leases as possible that classify as a capital lease due to the interest & amortization expense associated with a capital lease showing up in Interest and D&A expense. In contrast, an operating lease appears in COGS. Therefore, management's short-term EBITDA incentive comp benefits from the revenue of the bowling centers without the associated rental cost (interest & amortization). In 2024, rent expenses related to financing leases totaled $94.7m ($77m classified as interest expense and $17m from amortization). Since D&A is not added back for tax purposes, and capital lease expense flows through interest (instead of COGS like operating leases), ATI could be up to $94m lower, lowering cash taxes paid. Cash paid for taxes over the last three years is small ($6.37m, $2.24m, $6.19); management benefited on their incentive comp due to expenses moving from above EBITDA to below. Thus, the company paying more taxes is net positive for management but negative for shareholders. Furthermore, capital leases have longer durations, resulting in even more significant risk should the bowling center underperform expectations.
Another interesting perk of the job is the use of the company's aircraft. Under the Company's Corporate Aircraft Policy, Mr. Shannon and Mr. Parker are each entitled to use the company's aircraft for non-business purposes for up to 77 hours per year.
Lastly, the bull thesis is predicated on M&A. Management and the street add back "transactional and other advisory costs," which consist of "The adjustment for transaction costs and other advisory costs is to remove charges incurred in connection with any transaction, including mergers, acquisitions, refinancing, amendment or modification to indebtedness, dispositions and costs in connection with an initial public offering, in each case, regardless of whether consummated. Certain prior year amounts have been reclassified to conform to current year presentation." Certainly, these expenses are not one-time and are core to the business model. In FY23 and FY24, these add-backs totaled $23.6m and $21.3m, respectively. While the street adds these costs back to their estimates, I do not find this prudent.
Increasing Engagement – Just 1 More Game
Bowlero developed a gamification app called "Money Bowl." The app is a free-to-play and a real money wager against the center. Customers' challenges include bowling over 100, throwing a strike, and hitting a specific score. The free-to-play offers customers a free game, discounted beverages, etc. Real money involves the customer wagering against the center to complete a specific task. Management stated the goal is not to make money but to make bowlers return more often or play an additional game. This app's target demographic is males who enjoy gambling, ages 16-35. Beta version launched in Q4 2023. Management focuses a lot on this notion that if they can find a way to have customers bowl one additional game, given the 100% incremental margin, results in substantial EPS growth.
Unfortunately, the app flopped as management has not discussed the product since Q2, and the most recent review is from April 2024. The gamification idea is interesting, but it's a tough sell. 1. Setting up an account added friction that likely deterred customers. For something you're on the fence about, it's just another obstacle to overcome. (Reviews also made it sound like the app was buggy) 2. I don't know how big the potential market is. Personally - I don't see women getting involved in betting/gambling. I could see this working during a guy's night out, but I wonder if the competition against friends is more important than a free game. I'd also note men will typically wager amongst the friend group, i.e., the low man has to buy the next round of drinks. 3. Competitive bowlers probably enjoy the added challenge. On the other hand, these bowlers are likely coming back regardless of whether the app is interesting or not. Additionally, the reviews mentioned how difficult the challenges got after the first few levels, reducing engagement once challenges were out of reach.
Not having an app but instead having to opt in/out of the games on the computer screen when entering names would be better, with the rewards tailored to same-day prizes. For example, maybe a game card, additional game, ½ off food/beverage. The incremental margins on every aspect of the business are so high that giving away or discounting something (say ½ off a drink) would still result in incremental profit. F&B margins are ~80%. If you give someone ½ off a beer that retails for $5, with 50% off costs $2.50 results in Bowlero netting an incremental $1 profit. The cost of running the app and the lack of engagement in the interim have resulted in management putting the app on the back burner.
The average bowler comes to a center 1.5 times per year and bowls 2.2 games per visit. Management aims to increase visits to 2 times, and games bowled to 3. The average person bowls two games, while league bowlers typically bowl three. There are a few reasons why the jump from 2 to 3 for recreational bowlers is unlikely. First, a group of 4 will take about 1 hour per game to bowl. Similar to what's occurring in major league sports, the amount of time people are willing to spend at one spot is declining (MLB - pitch clock, NFL – expedited reviews). Second, while kids may want to bowl a third game to play the challenges, they are constrained by parents taking them to and from centers. Once again, it is unlikely that a parent wants to spend even more time at the alley. Finally, people get bored and want to leave during the third game. The jump from one to two games is far easier than from two to three. Customers will be reluctant to buy a third game, knowing that when that third game starts, they will be tired and would rather leave than play the third game. I can't tell you how often customers would leave mid-way through a game because they didn't want to finish, even though they already paid.
The long thesis for the stock centers around the roll-up strategy and consolidation of the bowling alley industry. Transaction multiples for these centers are in the 5-10x trailing EBITDAR range, according to management on the Q2 23 call. Previously, I estimated the EBITDAR to NI conversion of ~25%. However, accounting lease changes and leases classified as capital leases have made the conversion almost meaningless, given how significant Interest, D&A, and rent are to operate the business (it's marginally better than a community-adjusted figure at this point). In FY25, I estimate Bowlero will generate $373m in EBITDAR and -$9m in net income. Acquisitions on the low end likely need capital improvements, while those purchased at the higher end are likely turn-key or need minimal capex. Management claims their superior operating abilities cut the go-forward multiple in half.
Social Media
YouTube and Social media are playing a larger role than ever before. Whether it's Bryson DeChambeau growing the game of golf by playing with other celebrities or Mike Evans playing Fortnite with other YouTube content creators, the PBA has 308k subscribers. The largest content creator for the PBA is Darren Tang (I believe), who has 213k subscribers. Recreational golfers watch Bryson, while recreational bowlers do not watch Darren.
Valuation
Reverse DCF
Assumptions:
# of Centers: +7/year from 2028-2033, +5/year from 2034-2040, +2/year from 2041-2046, +1/year from 2047-2054. (In 2054, center count of 462 represents ~20% of total bowling alleys in the US(my estimate))
# of customers/center: +1%/year
Revenue/Customer: +4.5%/year
WACC: 11%
FCF Terminal Multiple: 10x
Catalyst
The sell side is incredibly bullish on the story, with 9 buys and 1 hold, likely because Bowlero is a friendly client for Wall Street banks. Estimates will move lower, and analysts downgrading the stock as results disappoint. Management does not anticipate price increases on the retail bowling side; however, food & beverage menu upgrades will naturally lead to higher prices. Embedded foot traffic is roughly flat y/y (my take on management's guide), and F&B menu changes and corporate spending increases drive management's guide of low- to mid-single-digit SSS comp growth. In line with guidance, I estimate they'll grow SSS by 3.4%, but I assume the traffic count will increase slightly, which could be aggressive. However, I could be light on F&B spending if the menu rollout performs well. Over time, management aims to have customers spend more on F&B than bowling. Instead of going out to dinner before/after bowling, they want customers to stay and eat dinner at the center. While Bowlero's Q4 results were far better than those of other entertainment companies (specifically TopGolf), I worry about the commentary from other retailers about consumer spending. Is Bowlero just that much better? I'll note that in the northeast, it appears we are in for a warm September, which is the start of bowling season. Should Summer/fall last longer than normal, demand for indoor activities could be weaker.
BOWL trades for 42x EPS and 35x EV/EBIT on my FY 2027 estimates, which are well below the street's 18x EPS (note the street figures are adj. numbers). The business's high leverage should correspond with a lower P/E multiple. Even putting 15x on "peak" EPS in 2022, which, yes, they've added centers and is not 100% apples to apples, results in an $8 stock. I expect both the multiple and EPS estimates to come down.
Risks & Where I Could Be Wrong
The primary risks are QMS (quantitative management solutions) and adjacent entertainment opportunities. QMS is Bowlero's proprietary management software, gathering internal data such as pricing, occupancy, labor hours, and other data to optimize revenue and expenses. For example, If the data consistently shows that lanes are fully booked on Fridays and Saturdays from 6-10 pm, the system would advise managers to increase prices. On the other hand, if it's a Tuesday night and the center has three workers, however, the center could operate with two; QMS informs management to schedule two workers instead of 3 moving forward. Management claims these efficiencies are the primary way to reduce purchase prices because legacy bowling operators have the same staffing regardless of what is needed to support the expected traffic. I am fully on board with this management system and believe it is a leg up on the competition. The real upside risk I see here is their potential to license this software to other operators in the restaurant, retail, or other businesses where labor is the dominating expense. Management has never discussed this strategy, nor do I know the potential market size. However, a revenue source with 100% incremental margins and no cost could dramatically improve the business.
Bowling is a global sport; however, Bowlero is a predominantly US-focused business with a few centers in Mexico and Canada. They could run the roll-up playbook in other countries, increasing their market size opportunity. In addition, they’ve begun expanding outside bowling, with recent water park and go-kart track acquisitions. Over the next several years, the primary focus is to expand the Bowling business through new builds and acquisitions. In 5+ years, we could see them make a larger push into adjacent markets. Management, excluding the founder Thomas Shannon, repeatedly discusses how they are not bowling operators; they are entertainment operators, making it a reasonable assumption that they will enter into adjacent activities in the future.
Should the new food & beverage menu updates attract greater wallet spend, my estimates are too low as 77% incremental F&B margins result in significant flow through. Management has rolled out different pass initiatives, including the summer pass, which generated over $8.5m in revenue, and is launching a fall season pass. Additionally, they are trying to drive traffic at off-peak hours through Groupon and other discounts. Driving incremental visitors at off-peak hours is incredibly profitable.
Conclusion
The company went public because it received a ridiculous valuation and capitalized on the opportunity to gain liquidity. High operating and financial leverage creates little room for error when foot traffic moderates and potentially declines. At 43x FY2027 earnings and 36x EBIT, the growth story and return on incremental investment/acquisition are well priced in. Downward revisions, underperforming business results, and continued selling from insiders are some of the many near-term catalysts. The short statistics below make earnings/event days particularly volatile.
Short Statistics (Source: Fintel)
Borrow Rate – 11.05%
Shares Short – 12.1m
Short interest % of Float – 57.81%
Days to cover – 11.94
Contact Information
Dominick D'Angelo, CFA
716-289-7222
dominick@okeefestevens.com
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