Geoff Gannon January 2, 2020

Geoff’s Thoughts on Cheesecake Factory (CAKE)

Someone asked me my thoughts on Cheesecake Factory. It’s a stock we’ve looked at before. But, I have written about it recently. The stock hasn’t done well lately. It looks fairly cheap. Here was my answer:

“I haven’t followed it lately. I know the stock hasn’t done that well. I did a very quick check of the stock price just now looking at the long-term average operating margin, today’s sales, today’s tax rates, etc. It seems that on an earnings basis (normalized for a normal margin on today’s sales) it would be about 13x P/E. That seems like a good price for a stock like this that has grown EPS almost every year. By the numbers alone, it reminds me of a Buffett stock. I was recently reading what I think is one of the best books on Warren Buffett. It’s called “Inside the Investments of Warren Buffett: Twenty Cases”. And one thing that stands out in each case study is his looking at the last 10-years or more of historical data. In time after time, the increase in revenue and net income and EPS year-over-year is positive in almost 10 out of 10 years. Sometimes it’s 9 out of 10 or something. But it’s very consistently positive compared to most stocks. Also, while people talk a lot about moats and high ROE – I’m not sure that’s as much as a focus for him. I think he looks more to find something that is already consistently showing good results year over year almost every year. Then, if the ROE is 20% or 30% – that’s enough for him. Because the stock is unlikely to be able to grow that fast anyway – it’s just a question of whether it can get a higher return on retained earnings than he can. ROE at Cheesecake Factory is generally adequate. It’s high enough that you could buy it based on its growth rate and P/E ratio. Now, I do notice that the 10-year results in terms of the top line really aren’t that strong. However, this has been true for a lot of restaurants in the U.S. I think Cheesecake also has the added problem that it doesn’t grow same-store real sales after the first year. These restaurants open VERY full compared to the industry. So, some companies have restaurants that do better in year 2 than year 1. That’s not the case here. But, the growth in things like earnings per share versus assets has been good. So, the economics have been – if anything – improving in terms of free cash generation versus the tangible assets used in the business. I’m not, however so sure it’s a growth stock anymore. But, in the company’s defense I think these last 10 years have been some of the toughest for restaurants. Inflation has been very low. Food inflation at supermarkets has been incredibly low to the point where eating in has been much more attractive than eating out. I don’t think that’s a permanent trend. And then you have increases in wages due to things like minimum wage laws and low unemployment. I would imagine that the combination of low inflation and low unemployment with some increases in minimum wages is very bad for restaurants like this. I know that some casual dining and fast food results have been substantially worse than Cheesecake’s results.

If I take the 3-year average free cash flow and ignore acquisitions – which I maybe shouldn’t – I get something like $3.80 a share in average FCF. Like I said, normalized earnings are like $3 in EPS. So, we have earning power of like $3-$3.80 a share versus stock price of like $39 a share. Maybe 10-13x P/E. Seems good. But, I like to look at the 10-year forward return expected from holding the stock. I think the company has only grown revenue by like 4% a year over the last 10 years. If they can’t get any economies of scale, etc. – then, that’s not a great number.  However, dividends are running like 3% yield on today’s price and buybacks like 2%+ most every year (sometimes a lot higher). Even if we just assume dividends of 3%, buybacks of 2%, and top line growth of 4% over the next 10 years that’d be an increase in FCF per share of 9% a year. Multiple expansion (from like 10-13x earnings to 15-16x earnings) could easily account for another 1.5% to 4% a year. I could see returns of let’s say 10-13% a year possible in this stock even if the 10-year future growth is closer to the 10-year past revenue growth than the growth in things like earnings, FCF, etc.
How low could growth in sales be and yet the stock return 10%+ over the next 10 years?
By my math, it’d be about 4% a year sales growth needed here. I think you can get no less than about 5% a year right now through a combination of buybacks and dividends and I think you’ll get another 1% a year or more from multiple expansion. That leaves a required sales growth rate of just 4% a year. I’m pretty sure the overall eat-in dining business in the U.S. won’t grow SLOWER than 4% a year nominal over the next 10 years Population growth is expected to be 0.7% a year from 2020 to 2030. Inflation / inflation expectations in the U.S. is about 2%. Lowest I can find is 1.8%. Highest is like 2.5%. Let’s call that something in the 2.5-3% range for population growth plus inflation. That means you need 1% to 1.5% in REAL growth in sales BEYOND growth of inflation plus population. I’m not sure this is faster than likely nominal GDP growth, because real output per capita can increase 1% to 1.5% in some decades. Maybe 1% is more likely than 1.5%, but still very possible. Also, I feel like eating out is a more likely use of people’s disposable income than additional amounts going to clothing, food at home, etc. So, I feel like entertainment and food and such outside experiences could increase AT LEAST as fast as nominal GDP and maybe faster. Nominal GDP might grow as fast as 6% or as slow as 4%. But, I doubt nominal GDP will grow much slower than 4%.
So, I see a path to 10%+ returns in Cheesecake Factory if the company can clear the hurdle of simply MAINTAINING ITS MARKET SHARE in the restaurant industry. Can it do that? I’m not sure. But, compared to most restaurant companies I think I’d be pretty optimistic. I think it’s a great model. Buffett doesn’t really buy restaurant stocks – but, I think it’s an area he could buy into. They often have predictable earnings actually. If I was managing unlimited amounts of capital – it’s something I’d consider.
It’s not overlooked enough for Andrew and I. But, it is a stock I think would be a good choice for any investors who:
1) Like restaurant stocks – feel they are in their circle of competence
2) Have eaten at Cheesecake Factory, feel they understand it
3) Would buy and hold the stock for a long time without worrying about where it trades
I feel most restaurant stocks over-respond to economic results, same store sales, etc. They tend to attract short interest for macroeconomic reasons. I think they’re actually pretty predictable when in a strong position competitively. As long as Cheesecake Factory’s competitive position doesn’t worsen over the next 10 years, I think you’ll make 10% a year. It’s something I’d definitely consider personally.”
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