The Cheesecake Factory (CAKE): A Second Opinion
Guest write-up by Vetle Forsland
Introduction
The Cheesecake Factory operates 208 restaurants primarily in the US. Of these locations, 194 of them are The Cheesecake Factory-restaurants, 13 are under the Grand Lux Café-brand, and one under the RockSugar Southeast Asian Kitchen mark. Additionally, they have 15 Cheesecake-branded restaurants in other parts of the world. These are all upscale casual dining restaurants. The customer eats freshly prepared food in the restaurant while a waiter provides table service. On average, a check from their restaurants was $21 (per person) in 2015, and $20.20 in 2016. The overwhelming majority (91 %) of the company’s sales comes from The Cheesecake Factory chain. The Cheesecake Factory restaurants offer high-quality food at moderate prices, with more than 200 items on their menu including 50 or so cheesecakes. It is known for its ginormous portion sizes and high-calorie dishes. Their core menu offerings include appetizers, pizza, seafood, steaks, chicken, burgers, pastas, salads and sandwiches, and they review and update their menu twice a year. The locations are large, open dining areas with a modern design. This means that Cheesecake Factory locations require higher investment per square foot than typical casual dining restaurants – but Cheesecake also has higher sales per square foot than competitors.
The Cheesecake Factory originated in 1972, when a small bakery opened in Los Angeles by Evelyn Overton. In 1978, her son, David Overton (who is still CEO of the company) opened the very first Cheesecake Factory restaurant. It was a huge success, with long lines on opening day. Overton quickly expanded the concept to other parts of the country, and in 1992, the company was incorporated as The Cheesecake Factory Incorporated in Delaware. Since 1997, Cheesecake has opened 11 restaurants a year, meaning an annual restaurant count growth of 15.8 % (7.4 % for the past 10 years). Management believes there is room for 300 Cheesecake restaurants in the US. Basically, this means that they will be able to open ~7-10 restaurants of their crown jewel a year for the next 10-15 years. In addition to this, the company is pursuing several incremental growth opportunities.
The stock price has fallen from a 52-week high of $67/share to $45/share (after dipping to $38 earlier this fall). This dramatic sell-off is most likely caused by declining same-stores sales. In May, Cheesecake reported a like-for-like growth of 0.3 %, and a -2.3 % decline in traffic. Restaurant chains often go through years of consecutive growth in same stores sales, with periods of consecutive quarters of declining same stores sales in between. So this is not very unusual in this business. The company also reported a decline of 0.5 % in Q2, which caused further sell-offs. Cheesecake stock has fallen about 35 % since the Q1 announcement. Furthermore, they are currently forecasting comparable sales decline of about 1 % for the full fiscal year.
Durability
The restaurant industry is a very durable industry. The demand for eating out is consistent in the US, and growing in many parts of the world as people’s income increases. Eating out as a percent of US GDP has solidly drifted around 4-5 % for the past 40 years. Restaurants go out of business not because of a decreasing demand, but because the industry landscape is very competitive. Therefore, Cheesecake’s future earnings power depends on the popularity of their crown jewel, The Cheesecake Factory, and how successful their other, smaller chains are. The durability of a restaurant company really boils down to how customers view their restaurant chains. As The Cheesecake Factory accounts for 91 % of the company’s sales, it is vital that the Cheesecake brand maintains its status and brand reputation. Basically, the question to ask is will the brand’s popularity prevail?
Americans in general are pursuing a healthier lifestyle, which means healthier diets. This is in theory bad news for The Cheesecake Factory. If you’ve ever eaten at one of their restaurants, you will know why. They are famous for their ginormous portions, loaded with calories; their entrees’ calories range between 1500 and 2500 – even a Caesar salad contains a whooping 1300 calories (the average American eats 2500 calories a day). Cheesecake countered by adding a “Skinnylicous” menu with a lower calorie count on their meals a few years back. What annoys me, is that they named it “Skinnylicious” which is embarrassing to say, so there’s a disincentive to ordering it. Consequently, The Cheesecake Factory is not a healthy option for your diet. Is America’s move towards a healthier style of living causing lower traffic to Cheesecake restaurants?
Probably not. The Cheesecake Factory has always been a chain where you go to treat yourself. People go to the restaurant not to eat healthy, but to eat reasonably priced tasty food, while socializing with friends or family. A huge part of the Cheesecake brand has always been the large portions they offer, and I don’t see traffic decreasing in the future based solely on healthier Americans. If anything, as The Cheesecake Factory is healthier than fast-food chains like McDonalds, traffic may even move from the fast dining industry to casual dining. But, this is very speculative, and I haven’t included this assumption in any of my growth projections.
A restaurant chain that stays popular will generate earnings for years. Cheesecake has had 0.8 % like-for-like growth annually since 2004, and 1.6 % annual growth on same restaurants since 1997. Same-store sales declined 4.6 % in 2008 and 2.6 % in 2009. So, Cheesecake restaurants lost 6.2 % of same-store sales during the financial crisis, while sales declined 0.3 %. Same-store sales also declined 0.6 % in 2006, and 1 % in 2017, according to estimates by the company. There is a chance that this decline continues – an example is Ruby Tuesday, a restaurant chain that has declined same-store sales for numerous consecutive quarters. This is less likely though. The Cheesecake Factory is a brand that has been popular since the late 70s. They have managed to adjust themselves to new trends, survived a number of financial recessions and have grown sales by 11.3 % annually over the past 20 years. Therefore, I believe that Cheesecake is in a stronger position than competitors to come back from the threatening decline in same-store sales. In 2016, the casual dining industry had comparable sales decline of 1.4 %, while The Cheesecake Factory grew same-store sales by 1.2 % (they increased menu pricing by 2.7 %, and customer traffic decreased by 1.6 %), and Grand Lux Café grew 2.2 %. The casual dining industry as a whole is struggling.
One of the biggest concerns about The Cheesecake Factory, is that many of their locations are in malls. Site locations are mostly “urban or suburban shopping malls, lifestyle centers, retail strip centers, office complexes and entertainment centers.” Therefore, future traffic may be dependent on how shopping malls will perform in the future. As online shopping is growing at a rapid rate, traffic to malls consequently declines. But, the company is actively seeking high quality locations, where traffic isn’t necessarily dependent on the performance of retail stores – it is more so a place for people to meet and socialize, or shop at very specific stores. According to Cheesecake, they intend to “continue developing The Cheesecake Factory restaurants in high quality, high profile locations that meet our rigorous site standards.” Another point to consider is that The Cheesecake Factory is a very popular chain, and the name itself attracts customers. This helps Cheesecake overcome the decreasing traffic to malls. It’s also important to keep in mind that these shopping centers are often different from the traditional American mall, in that they are not just a compilation of tens of retail stores – hence “high quality locations”. All in all, I think Cheesecake is facing some serious trouble as a mall-focused restaurant chain. The management has not addressed this issue in a good manner, or shown signs of being proactive. In their Q1 conference call, they mentioned social media and “special menu items cards” as things the company is doing differently.
Quality
The Cheesecake Factory is a good business. Firstly, EBITDA margins are very stable. Since 1997, Cheesecake’s operating margins have been 13.3 %, over the last 10 years. It has never dipped below 10 % except on one occasion (9.3 % in 2009), and its highest operating margin was in 2016, with 17.7 %. Over the last 20 years, margins have been very steady in between 11 %-15 %. At the same time, EBIT margins are usually around 8 %. It has in the past been as high as 10 %, but on average Cheesecake’s EBIT margin has been 7.4 % since 2007, and 8.5 % since 1997. What’s remarkable is how stable gross margins have been. Since 1997, Cheesecake’s gross margins has averaged 76 %. They have consistently – with one exception – been around 76 %. In fact, 2006 was the only year in which Cheesecake didn’t have gross margins in the 74 % – 77 % range, in which their margin was 98 %. In other words, it’s a stable business.
For 20 years, Cheesecake has generated pre-tax returns of about 22 %. Returns on capital have been especially strong since the financial crisis, with pre-tax returns of 29 % since 2010 and 26 % since 2007. Return on equity has mirrored pre-tax returns, erring 1 percentage point on the negative side. In comparison, Darden Restaurants and Bloomin Brands have returns of 23 % and 22 %, respectively.
The Cheesecake Factory brand is a strong one. With over 200 locations, it’s one of the bigger fine casual dining chains in the US, and management believes it has room to grow to 300 locations (not including expansions to for instance Canada). There are almost no marketing and advertising expenses needed for the brand. It spreads through word of mouth and social media – Cheesecake had 2 billion social media impressions in 2016, and has 5.1 million likes on Facebook. I think of the restaurant chain as a place you plan to go to ahead of time. If there is a Cheesecake Factory in your town, you go out to eat at Cheesecake, and certain times you do nothing else in particular. Other casual dining chains are places you eat at if you are already doing something in a city, like for instance shopping at a mall.
Cheesecake’s locations are fairly big, at 5000 – 21 000 square feet. New locations will be around 8000 – 12 000 square feet, according to the company. The Cheesecake chain have seemingly happy employees, which is important in an industry where good customer service is essential. It was the only restaurant to appear on Fortune Magazines’ “Top 100 best companies to work for” ranking, for the third year in a row. Furthermore, it had $10.7 million in average sales per location in 2016, which is a high number compared to other restaurants. Sales were $971 per square foot, which again, is higher than the industry average. Bahama Breeze and Yard house has $857 and $713 of sales per square foot, respectively (both owned by Darden Restaurants). Texas Roadhouse is the fourth most efficient restaurant in terms of sales/square foot, with $698. Most casual dining restaurants have around $500-600 worth of sales per square foot. Furthermore, opening a Cheesecake Factory restaurant is a happening. New restaurants perform best at first, and settles to normal after 3-6 months – this may prove that the chain is a destination, rather than a place to eat when you are hanging out in a shopping mall.
Growth
Since 1997, the company has on average grown sales by 13.8 % yearly. However, it has only grown 6.2 % a year since 2007. This is partly because of the financial crisis. But it is mostly because there were more (attractive) locations to build Cheesecake restaurants in 1999 than in 2009, and there are a lot fewer places available in the US today. Still, management believes there is room for at least a hundred more locations in the US. Cheesecake will probably grow sales annually by 5-6 % over the next 10, 15 and 20 years. So it qualifies as a growth stock. The company will probably be able to build at least 8 Cheesecake-owned restaurants (including Grand Lux Café) a year for the next decade. Furthermore, existing Cheesecake restaurants will probably grow same-store sales by no less than 1 %. They have grown same-store sales by 1.6 %, 0.8 % and 1.7 % since 1997, 2007 and 2011, respectively. I think same-store sales growth of 1.2 % is a reasonable, but conservative, assumption.
Sales in 2016 were $2.275 billion. Considering a 1.2 % like-for-like growth for 10 years, and sales will be $2.570 billion in 2026. By adding the extra growth from new locations, Cheesecake will have $3.410 million in sales, purely from same-store sales growth and adding 80 new locations for 10 years. This is a compound annual growth rate of 4.13 %. In addition to this, Cheesecake has licensing agreements with three restaurant operators for the Cheesecake brand outside the U.S. The company does not invest capital to build these international locations, and there are 15 in total today. Cheesecake expected in their Q3 earnings call to open four restaurants under licensing agreements in 2017, and 4-5 restaurants to open in 2018. They have told the public few financial details about the licensee agreements. However, Cheesecake in 2013 forecast a $0.01 annual EPS contribution from each Middle East location open more than one year, and has also said that licensing restaurants will add “more than 1 cent per share” a year. The three first Cheesecake restaurants in Dubai and Kuwait collected sales volumes that “far exceed” those of U.S. locations, according to former CFO Douglas Benn.
Given that Cheesecake opens 4 licensee restaurants a year (they have estimated 3-5) that adds $0.01 to EPS every year for 10 years, the company will receive $20.8 million by a decade’s time. While this isn’t a lot in terms of sales volume, it certainly adds to their free cash flow, as there’s zero capital expenditures necessary for licensed restaurants. $20.8 million added to $187 million free cash flow is a 1.06 % increase annually.
This increases the 10-year growth rate to 5.2 %. In addition to growing the brand domestically and by licensing, the management is pursuing a number of incremental growth opportunities. Rock Sugar Asian Kitchen is a fresh chain from Cheesecake with only 2 locations. The company has also made small investments in new restaurants North Italia and Flower Child. This will probably have very little impact in the foreseeable future. Furthermore, they are developing a fast casual concept, and are making consumer packaged goods sold in stores, like cake mixes and ice cream. Both of these ideas are very speculative, so there is no way to say how much they may add to sales. So, while Cheesecake is looking for a number of growth opportunities, it’s not easy to predict how they will impact future earnings.
Value
Free cash flow was $186.7 million in 2016, while 3-year average FCF is $131.3 million. This yields 6.5 % at $44 a share. Cheesecake uses 78.4 % of this money to buy back its own shares, and 22.7 % to pay out dividends. The company has paid dividends every quarter since June 2012, and the buyback program has no expiration date. A 6.5 % FCF yield plus yearly growth of 5.2 % equals a potential annual return of 11.7 %. However, Cheesecake issues stock options to employees, which dilutes the share count by 1.5 % yearly. Therefore, expected return may be 10.2 % before margin expansions.
Revenue for 2016 was $2.275 million, times a normal EBIT margin of 8.5 % and pre-tax owner earnings for 2016 was $193.4 million. A fair multiple for a good, growing, restaurant stock is probably around 15x EBIT, which is equivalent to $2.901 million (minus net debt of $51 million) = $2.850 million in future value. Divided by 49 million shares outstanding, and a fair value on The Cheesecake Factory is $58.20/share. This means that the stock is trading at 76 % of intrinsic value.
A share price increase from $44 to $58.20 is a 32 % increase. If the price expands by that much, your returns will be boosted as follows:
5-year holding period: +5.7 % annually
10-year holding period: +2.8 % annually
So, if Cheesecake returns about 10% a year, and you bought the stock today and held for 5-10 years during which the stock is re-valued by the market up to what I think it should trade at, your annual return expectation would be something like 13 % to 15.9 %. Obviously, these numbers increase as the stock price decreases more (that is, if you manage to buy below $44 a share).
Buying Cheesecake at $44 a share can lead to a 13-16% long-term return. At the same time, the management is pursuing several growth opportunities that may boost the stock return even more. But, it’s not a risk free stock, as the CEO is getting up there in age, and American malls are looking at decreasing traffic, where many Cheesecake restaurants are located.