The Cheesecake Factory (CAKE)
Guest write-up by Jayden Preston
Fellow Focused Compounding member Kevin Wilde has written two posts on The Cheesecake Factory (over at the “Idea Exchange”). I suggest you read his posts first to get a better glimpse at the company’s financials. This article is intended to be a more qualitative one.
Overview
Originated in 1972, the predecessor of The Cheesecake Factory was a bakery operation founded by the parents of Chairman David Overton in Los Angeles. In 1978, David Overton led the creation and operation of the first The Cheesecake Factory restaurant in Beverly Hills, California. This essentially led to the inception of the upscale casual dining segment in the US.
Fast forward nearly 40 years, The Cheesecake Factory now operates 209 Company-owned restaurants, comprised of 195 restaurants under The Cheesecake Factory brand name; 13 restaurants under the Grand Lux Café mark and one restaurant under the Rock Sugar Pan Asian Kitchen name. Internationally, 18 The Cheesecake Factory restaurants are operated through licensing agreements by their partners overseas. The Company also has a baking segment, running two bakery production facilities in the US. All the cheesecakes served in their restaurants, including international licensees and third party bakery customers, are made at either of these two facilities.
Operating in the upscale casual dining segment, their average check per customer, including beverages and desserts, is above $20 per customer.
In Nov 2016, they have also invested $42 million for minority stakes in two concepts, North Italia and Flower Child, and will provide growth capital for them going forward.
As restaurants bearing The Cheesecake Factory brand still delivers most of the value in this company, we will focus our following analysis on them.
Major Differentiation Points
Their restaurants are different from most restaurant chains in the following ways:
- Except their desserts being produced at their bakery facilities, substantially all other menu items are prepared from scratch locally at their restaurants, with fresh ingredients.
- Their restaurants are huge with size ranging from 8,000 square feet to 12,000 square feet.
- The capital investment per square foot for each of their restaurant is thus higher than most, even in the casual dining industry. It usually costs $8 million or more to set up one new restaurant.
- Offsetting point number 3 is the unusually high sales per square foot generated in their restaurants. Particularly, the average The Cheesecake Factory restaurant generates above $10 million in sales per year, averaging close to $1,000 in sales per productive square feet.
- Extensive menu covering a huge variety of dishes, appealing to a diverse customer base across a broad demographic range. The Cheesecake Factory menu features more than 200 dishes. The menu is updated twice every year.
- Higher percentage of sales from desserts than average. Dessert sales was 16% of revenue in FY2016.
Durability
The business of restaurants is durable as long as humans exist, because I believe eating out will never go extinct. Instead, a discussion on durability needs to be addressed on a single restaurant brand basis, mainly on the topic of “Concepts”.
Restaurants are tough businesses. While recent research has clarified that only 17% of restaurants, not 90% as widely quoted, fail within their first year of operation in the US*, the fact remains that most new restaurants, especially smaller ones, started each year will no longer exist within the next few years. Some put the failure rate within 5 years at 80%**.
Yet, even if a restaurant has been highly profitable for a few years in a row, we still should look at how that’s achieved. From time to time, there are different food trends within the restaurant industry. A restaurant can easily ride on an ongoing food trend to huge profitability for a period. Yet, this also means the bulk of the business could vanish once the trend fades. To a large extent, this is the element in teenage fashion brands that make their business less durable. Usually with a high fixed cost structure, a restaurant has little leeway to manage declining turnover.
In the case of The Cheesecake Factory, this is less of a concern than many other restaurants. First of all, their restaurants are more linked to cheesecake than any other single type of cuisine. With more than 200 items on their menu, their restaurants provide a huge variety of dishes. As such, The Cheesecake Factory brand is more associated with quality food at an affordable price than any particular trend in the food industry. Their ability and willingness to update their menu twice each year also makes it easier for them to navigate changes in customer preference, making sure they stay relevant in customers’ mind. The close to 40 years of successful operation is a testament to The Cheesecake Factory’s ability to attract customers continuously despite different food trends throughout the years.
However, the concept of The Cheesecake Factory is more than just a large menu. Locating in A grade malls is another key element. Here, the threat to their durability could be further deterioration in the traffic of shopping malls. I am not overly worried about this either though. Given the need to socialize with others, there will always be a need for a place to gather. And food will always be a big part of the place. Should the current shopping malls lose their importance over time, other sites with different formats would crop up and replace them. As the crowd moves, The Cheesecake Factory will follow. Moreover, we can have high confidence that The Cheesecake Factory will get invited in new sites due to its ability to attract crowds.
Moat
Geoff recently wrote a blog post where he answered questions about The Cheesecake Factory. In it, he said:
“1) I don’t think Cheesecake Factory (CAKE) has a moat. Everyone goes to multiple restaurants. The most successful restaurant chains do a good job of compounding wealth for shareholders and earning high returns on capital. But, no restaurant is insulated from competition with others. So: no moat.”
So Geoff doesn’t think The Cheesecake Factory has a moat. I rarely find myself in disagreement with Geoff. But this time is an exception.
How I think about CAKE’s moat may not be important and the difference between my thinking and Geoff’s might just be semantic though. Both Geoff and I like CAKE. As an upshot, my conclusion on the company doesn’t differ from Geoff’s.
When I think about moats of a company, I tend to think in terms of how easy a competitor can replicate what the company does. Had you read through the “Competitive Positioning” in their annual report and gone to any The Cheesecake Factory before, you ought to get an impression that what they do is not easy.
Here are the six points they listed as their sources of competitive strength:
- Extensive and Innovative Menu
- Commitment to Excellent Service and Hospitality through Selection, Training and Retention of High Quality Staff Members
- High Quality, High Profile Restaurant Locations and Flexible Site Layouts
- Distinctive Restaurant Design and Décor
- Value Proposition
- Integration of our Bakery Operation
As mentioned, CAKE has one of the most extensive menus in the industry. To prepare all the required ingredients and sauces locally at each restaurant, fresh every day, is a major challenge.
And to be able to execute this strategy effectively, you need high quality staff. More importantly, you need a relatively stable staff base so you do not have to train a big portion of your staff every few months. The importance of staff in a restaurant cannot be overstated, since The Cheesecake Factory competes in the upscale casual dining segment where customers take into account services in their total experience. This is why the Company puts “High Quality Staff Members” second in the above list. Each of their restaurant is staffed with approximately 170 hourly staff members. That’s a big number. Finding enough quality members and retaining them is a tall task.
Location and design of the restaurants are also important as these constitute their brand. Numbers of locations in A grade malls with adequate size is limited. This creates a certain degree of barriers to entry for new entrants. In other words, being more of an anchor tenant that attracts traffic, landowners would be more inclined to continue their lease to The Cheesecake Factory than a new restaurant.
The Cheesecake Factory is a “volume” concept. Given their commitment to an extensive menu and prime location with large space, they could only make a good return on their investment through higher than normal volume or sales per square feet. The best way to achieve that is to provide a good value proposition to your customers. And of course, as volume goes higher, the Company accumulates better bargaining power against its suppliers and landlords. A mini positive feedback loop is thus formed.
Last but not least, having their own bakery operation makes sense for them given the amount of cheesecake they sell each year. Again, with more volume, they can afford to spend more of their resources on their bakery operation. Better control of their key selling products creates more room for differentiation.
In aggregate, we can see a lot of factors work together to make The Cheesecake Factory a pretty unique and difficult to replicate restaurant operator. They have all the right attributes that create a successful restaurant chain. I would assert that with the above multiple elements, CAKE has a certain level of mind share that is difficult for competitors to steal.
Undoubtedly, as Geoff mentioned, people go to multiple restaurants and no restaurant can insulate itself from competition with others. However, to a restaurant, what’s crucial is not keeping customers all to itself. The key is to attract enough traffic. This can be done through occasional attention from a large number of customers. You do not need anywhere close to 100% of the attention from all your customers. It’s more important to have enough people to always think about your restaurants and have a meal at them from time to time. If your mind share is resilient to enough customers, then you will have adequate traffic for your restaurant to be a good business. Again, I do not agree that one should equate low barriers to entry as an absence of a moat.
To retain mind share in the restaurant business, the necessary ingredients include offering good value on quality food consistently and giving customers good surprises regularly. From 1 restaurant to just under 200 in the US and with one of the highest sales per square feet in the industry, year in and year out, The Cheesecake Factory has shown that they are one of the best to perform both.
Their same store sales also usually perform better than industry average. The strength of The Cheesecake Factory brand is especially prominent during years of market downturn like 2017. For instance, the overall restaurant industry faces a decline in same store sales of roughly 3% this year. For CAKE, the expected full year decline is only 1%. Furthermore, another testament to their brand power and great positioning: The Cheesecake Factory rarely has to close a location. They only mainly do so to move to a different nearby location or if they decide not to renew a lease due to a change to the mall.
It is in the sense of maintaining their disproportionately large mind share in the upscale casual dining segment that I would say The Cheesecake Factory has a defensible moat.
It’s reasonable to argue that The Cheesecake Factory’s moat is mostly a result of excellent execution. Yet, you would realize that this is not exactly true when you examine the other brands under the company. Despite being run by the same top management, Grand Lux Café hasn’t been as easy for them to grow as it has been with The Cheesecake Factory branded restaurants.
Growth
One of the downsides to CAKE’s business model is the limited opportunity for growth. Their restaurants pretty much operate at full capacity from the opening. As such, same store sales growth usually only tracks inflation in the long run. They must rely on unit growth for overall growth. However, because their restaurants are sizable and only operate in A grade malls, the maximum potential number of stores they can open is also limited. Management has long been estimating that there can be 300 The Cheesecake Factory restaurants in the US. That’s 50% more than the current level. In the latest earnings call, management suggests they can keep growing unit store count by 3% to 4% annually in the medium term. This matches their yearly opening in recent years at around 8 to 10 stores per year. Should they grow their US store count by 3.5% a year, it will take them roughly a decade to reach 300 restaurants.
It’s important to remember that the growth will not be smooth, since they are reliant on finding the best locations. Their rate of new restaurant opening is highly dependent on the high-end mall industry. When the real estate market for high end shopping malls are weak, especially when new developments are being delayed, such as during the 2008/09 Financial Crisis, the rate of opening could drop to near zero.
So, what happens after 2028 when the US market saturates for the Company? The answer to this question is more speculative than anything in this article. But just to give you a rough idea there are several more avenues for the Company to grow:
First, they can look to expand more aggressively outside the US, such as Canada. They have also started their international franchising system a couple years back. They now have stores in the Middle East and Asia. In 10 years’ time, the international segment could have grown a lot bigger. CAKE expects to add 3 to 5 international licensed restaurants per year for the foreseeable future.
Second, there are two other wholly owned brands, Grand Lux Café and Rock Sugar Pan Asia, under the Company. As the market for The Cheesecake Factory saturates, more resources and attention could be utilized to grow these two concepts.
Thirdly, their recent investments in North Italia and Flower Child could be additional avenue for growth.
Moreover, CAKE is also looking at expanding its consumer packaged goods sales.
Finally, the Company has announced they are developing a new fast casual dining concept internally.
All these new initiatives may provide little to a whole lot of additional boost to growth. It’s prudent if we do not value them at all.
Valuation
What might The Cheesecake Factory be worth if we only assume growth up to 2028?
In FY2016, CAKE generated $2.28 billion in revenue and $201 million in operating income. In terms of cash flow, cash provided by operating activities was $300 million in FY2016, $235 million in FY2015 and $240 million in FY2014. Capital expenditure were $116 million in FY2016, $154 million in FY2015 and $114 million in FY2014. There was also stock-based compensation ranging from $17 million to $21 million. Taking away stock-based compensation, 3-year average free cash flow in the past 3 years was $112 million. According to Kevin Wilde, we know that the operating margin at CAKE has consistently been around 8% over the past 25 years, with cash flow from operations consistently at 150% of operating income. A quick look at the results from FY2014 to FY2016 shows that the average of these 3 years is not abnormal.
Over time, The Cheesecake Factory has had no trouble raising prices along inflation rates. With around 1.5% price increase and 3.5% unit growth, we can expect free cash flow growth of at least 5%. This would suggest The Cheesecake Factory could be generating around $191 million in free cash flow by 2028. If they stop increasing store count by then, their free cash flow should be even higher.
The Cheesecake Factory branded restaurants are not cheap to build. Total costs are targeted at approximately $900 per interior square foot. At 8,000 to 10,000 square feet per restaurant, the total investment cost would have been at least $65 million for the 8 new restaurants.
This implies that another $65 million or more of cash flow could be freed up. Moreover, there would be no pre-opening costs beyond 2028. That is another $15 million or so per year. Altogether, this pushes their free cash flow in 2028 above $270 million.
Should they then only grow alongside inflation of 1.5% to 2%, a conservative multiple on this free cash flow stream would be around 15x. (6.7% free cash flow yield growing 1.5% means a total return of 8.2%) This gives them a market capitalization of $4.1 billion by 2028. At $2.1 billion now, this points to a 6.9% per annum capital gains being possible even without any contribution from other growth initiatives between now and 2028, and just inflation growth afterwards. Per share value should grow faster since CAKE has a regular share buyback program. Investors should also expect dividend income along the way.
In any case, I believe The Cheesecake Factory is pretty obviously mispriced in this current market. Even just looking at growth in US based The Cheesecake Factory restaurants, the stock can reasonably match the long-term stock market return, despite in a market priced to generate a return much lower than it has historically.
Misjudgment
The reason why the CAKE’s shares has dropped more than 24% this year is due to the weak restaurant environment in the US this year. As mentioned, the industry as a whole is seeing negative same store sales as high as 3%. Should we expect this trend to continue? Geoff and I do not believe so. As Geoff has pointed out elsewhere, the main driver for the weak comparable restaurant sales in the industry is due to a rare instance of possibly unprecedented divergence between food price at supermarkets and food price at restaurants. In an effort to gain market share, grocers have marched into a costly price war.
Here is what Geoff said in the blog post referenced above:
“2) Yes. At some point, prices of food in supermarkets will rise faster than prices of food in restaurants. Several publicly traded supermarkets had EPS declines of 10% to 20% this year. That won’t continue indefinitely. At some point, they will have to open fewer new stores, close some existing stores, and raise prices. Food at home prices have fallen because retailers have accepted pricing that earns them less money. What’s happened is not that food costs are down. It’s that supermarket profits are down. The cycle will get worse as long as rivalry in food retail gets more intense and then it will get better only once rivalry in food retail gets less intense. Right now, food retailers are more intense rivals than restaurants. I haven’t seen anything that changes costs in food. I’ve just seen supermarkets and other retailers lowering prices without lowering costs – and thereby lowering profits for themselves and their competitors.”
Since the current situation is based on an unsustainable price war, we should not be worried about the current negative same store sales environment for the industry affecting CAKE’s future.
The bigger risk for investing in CAKE is whether there really is room for 300 locations for The Cheesecake Factory concept. Even though I have argued that declining traffic to malls is not a concern to me due to my belief that there will always be locations, in whatever formats, where people spend time together. Nevertheless, the societal shift from visiting malls could mean there will be a decline in the maximum number of A grade malls. Besides, the new format may entail different sizes and thus the maximum number of locations available in the US may change for them. For instance, think about the difference between a department store and a shopping mall. If this is the case, CAKE may find it difficult to add another 100 locations over the next decade.
My biggest concern is how CAKE would perform once David Overton steps down from the company. The Cheesecake Factory is a highly complex concept to execute. The brand could lose significant mind share should their food quality and service consistency start to drop. As the founder, Chairman and CEO of CAKE, Overton has demonstrated that he is an excellent restaurant operator. He is known to be present at restaurant openings, especially in overseas locations. The point is he is very much involved in the business. Unfortunately, he is 71 years old now, and we have no reference to how the business would have done had it not been him at the helm. While it’s certain there are teams that manage, site selections, site openings, day to day restaurant operations, purchasing, and so on, the fact that there is not a concrete succession planning is a concern to me.
Conclusion
Restaurants may not have a moat under most definitions, as they cannot vend off competitors. However, being a highly-differentiated concept with broad appeal and consistent quality, the mind share The Cheesecake Factory commands is difficult to take over.
Buying shares of The Cheesecake Factory now is akin to buying a business encountering temporary problems. Only this time, it’s even better as we know the CAKE brand is still strong. The only obvious trouble is the temporarily weakened industry CAKE is in. Should one of the growth initiatives succeed, an investment in The Cheesecake Factory will prove to be as delicious as their cheesecakes.
** https://www.cnbc.com/2016/01/20/heres-the-real-reason-why-most-restaurants-fail.html
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