We came across a bearish thesis on Bowlero Corp. (BOWL) on The Lion's Roar - Outside the Box Investments’ Substack by Dominick D'Angelo. In this article, we will summarize the bulls’ thesis on BOWL. BOWL Technologies, Inc. share was trading at $11.72 as of Oct 7^th. BOWL’s trailing and forward P/E were 24.12 and 55.87 respectively according to Yahoo Finance.

Bowlero, a De-SPAC company founded in 2021, is the largest operator of bowling centers in North America, managing 352 centers mainly in the U.S. under the Bowlero, AMF, and Lucky Strike brands. It also owns the Professional Bowlers Association (PBA). For fiscal year 2024, Bowlero’s revenue is diversified: 49% from bowling (including league play, retail bowling, and shoe rentals), 35% from food and beverage sales, 15% from amusement revenue (arcades and other games), and 2% from media revenue (related to PBA tournaments and licensing media content).

The company is following a Private Equity leveraged buyout (LBO) roll-up strategy, acquiring and renovating bowling alleys and developing new locations to improve operations. The bowling center industry is fragmented and faces challenges like declining popularity, reduced league participation, and center closures. According to IBIS World, there were about 2,701 bowling centers in the U.S. in 2023, a 3% decrease from the previous year.

The company does not inspire confidence as its financial reporting practices especially focus on EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) as a measure of financial health. EBITDA is net income plus taxes, interest expenses, and depreciation and amortization. Bowlero, which leases 340 of its centers, often uses EBITDA and sometimes EBITDAR (Earnings Before Interest, Taxes, Depreciation, Amortization, and Rent) to present its financial performance. This can be misleading as it excludes significant costs like annual rent expenses of about $240 million. The treatment of capital leases as debt further complicates the financial picture, with around $94 million in annual capital lease expenses excluded from EBITDA calculations.

Bowlero’s financial strategy relies heavily on $1.15 billion in variable-rate debt, currently around 8.6%. A 1% change in interest rates could lead to an $11.5 million variation in interest expenses. As interest rates are expected to decline, Bowlero might benefit from reduced interest expenses, providing some relief amid high financial leverage. The operational model is capital-intensive, especially as Bowlero aims to acquire and upgrade outdated centers into premier entertainment venues. Recent openings in Miami and Beverly Hills have been positioned as upscale entertainment hubs. However, ongoing operational costs require careful financial management, with depreciation and amortization averaging 9-10% of revenues. In FY24, D&A related to property, plant, and equipment amounted to about $121 million. Total expenses excluded from EBITDA—including $66.4 million from capital leases, $28.3 million in financing obligation interest, $100 million in debt interest, and $120.8 million in D&A—total about $315.5 million, or nearly 27% of Bowlero’s total expense base of $1.171 billion. This shows that EBITDA does not accurately reflect free cash flow, especially considering net operating loss (NOL) carryforwards.

Bowlero’s reliance on high operating and financial leverage poses risks, particularly during downturns. Recent tax code changes since 2022 have affected the calculation of Adjusted Taxable Income (ATI), limiting the deductibility of interest expenses. Bowlero’s high-interest expense relative to ATI restricts allowable interest deductions, complicating its financial landscape. The shift from EBITDA to EBIT as a proxy for ATI highlights vulnerabilities in Bowlero’s capital structure, where interest expense deductibility has become constrained. Bowlero’s reliance on long-term, non-cancelable lease agreements highlights a fragile financial model. These leases, some extending until 2047, increase fixed costs and limit flexibility to adapt to market changes. This debt-heavy growth strategy could strain resources in tough economic times.

Additionally, management’s interests appear misaligned with those of shareholders. Founder Thomas Shannon’s control through Class B shares raises concerns about decisions prioritizing personal goals over shareholder value. The incentive structure based on EBITDA encourages management to sign long-term leases that reduce current rental costs, potentially ignoring economic realities. Bowlero’s attempts to boost customer engagement with the “Money Bowl” gamification app have not been successful, as user feedback indicates engagement barriers. The operational efficiency of its bowling centers could improve with simpler incentive structures that encourage immediate customer participation.

Overall, Bowlero’s path, characterized by high leverage, significant operational costs, and misaligned management incentives, presents considerable risks for investors. They must be cautious of economic stress revealing weaknesses in Bowlero’s financial structure.

Bowlero Corp. is also not on our list of the 31 Most Popular Stocks Among Hedge Funds. As per our database, 14 hedge fund portfolios held BOWL at the end of the second quarter which was 13 in the previous quarter. While we acknowledge the risk and potential of BOWL as an investment, our conviction lies in the belief that some AI stocks hold greater promise for delivering higher returns, and doing so within a shorter timeframe. If you are looking for an AI stock that is more promising than BOWL but that trades at less than 5 times its earnings, check out our report about the cheapest AI stock.

READ NEXT: Analyst Sees a New $25 Billion “Opportunity” for NVIDIA and 10 Best of Breed Stocks to Buy For The Third Quarter of 2024 According to Bank of America.

Disclosure: None. This article was originally published at Insider Monkey.