Have your CAKE...?
Today, we’ll walk through an investment analysis of The Cheesecake Factory (CAKE). I’ve actually been an owner of Cheesecake Factory shares for a couple of years now. But the recent market malaise (aka storm, destruction and rampaging bear as quoted in the financial press) has given us an opportunity to purchase shares at prices not seen since just after the new millennium. I don’t have a set checklist that I walk through when I examine individual companies, but I do have areas of focus to develop the investment story, and I will walk through those for illustrative purposes.
Overview:
The Cheesecake Factory operates 139 (as of April, 2008) Cheesecake Factory restaurants described as “upscale, full-service, casual dining restaurants” in their SEC filings. Additionally they operate 13 Grand Lux Café’s and opened their first RockSugar Pan Asian Kitchen (don’t you just LOVE that name…) in LA. The Cheesecake Factory was started in 1972 by Oscar and Evelyn Overton. They opened their first restaurant in Beverly Hills in 1978 with the help of their son David. Today David Overton is the Chairman and CEO. He currently owns over 5% of the outstanding shares (3.7 million shares of 67 million) worth about $45 million.
The Common Sense Test:
I like to see if I an investment thesis passes muster from just a common sense stand point. So, how about CAKE? Well, they certainly operate in a tasty and understandable operating segment. They’ve grown their revenue nicely over the last 10 years at about a 22-25% clip. I’ve eaten there and found the food delicious and interesting. The restaurants are always packed (although I’ve never eaten at a Grand Lux – let me know if you have, I’d be interested in your opinion). We’ll get more into valuation in a minute, but one of the things that attracted me to the stock has been its significant drop in price. It’s now trading in a range not seen since Feb-April 2000. Just for grins, I looked at their annual report from year ending 1999. At that time, they operated 34 total restaurants and had revenues of $347 million. As of yearend 2007, they had 153 restaurants and $1.5 billion in revenue. Yet now they trade for the same split adjusted price per share. From a common sense standpoint, it certainly seems as if the business value should be significantly higher today than eight years ago.
Investment Thesis – Bear Case
Whenever I look at an investment – particularly when I look at contrarian investments (which I do a lot, I like to buy things on sale) – I try to understand the bear case first. Sometimes it helps to be a cynic. It also helps to try to understand why someone is willing to sell, hey, they might be right at the end of the day.
For the Factory, the bear case seems straightforward – it’s really a matter of the one-two punch anyone in the consumer discretionary arena is dealing with today. Lowered consumer spending and sentiment driven by the credit crisis and gas prices (one, ouch) coupled with higher input costs due to commodity inflation, particularly food (two, ouch ouch). Normally, I’d look for signs that there are operational issues here, but that doesn’t seem to be the case, management seems competent and well motivated and Mr. Overton is certainly aligned with shareholders given his monetary investment in the company. The prevailing expectation seems to be that CAKE’s margins will get squeezed due to lower revenues as people pull back their spending and increased ingredient cost due to commodity inflation. Additionally, CAKE has always been debt free, but recently took on $275 million in debt, primarily to fund share repurchases.
The Bull Case
While I think the outlook for the Bear case is accurate, and I don’t see much chance of CAKE escaping the short term margins squeeze, I think the long term case for the company might be much better. Management seems cognizant of the short term challenges and intent on addressing them. They have reduced the number of store openings this year to 8-9 v. 21 store openings in 2007. They plan to funnel the cash freed up to repurchase shares – and when management repurchases shares, it’s a pretty good indication that they feel the price is undervalued.
As to the margin impact, current operating margins are good but not stellar. For example, the operating margin for CAKE runs about 7% against an industry average of 5%. Competitors such as Darden’s and Brinker’s sport operating margins in the high 7% range. While CAKE isn’t best in class (yet), it seem far enough ahead of the pack that they should be able to survive the short term margin squeeze they are living through at the moment. One thing that makes me confident in CAKE’s ability to do this is their potential pricing power. If you have been to Cheesecake Factory, you might be surprised to see the length of the line on a Friday or Saturday. They typically run at 95% and upwards of peak capacity – this is a popular concept. In fact, not long ago (when times were better) I read a negative review by an analyst panning the stock because at 95% capacity, they had little likelihood of driving comparable store sales growth! The point being, when you have a devoted following, you will be able to pass the costs along to the customer. The lag between rising costs and the timing to effectively raise menu prices guarantees that you will reduce your margin in a rising cost environment. However, I expect that CAKE will be able to pass along cost increases to their customers when they update their menus (which they do twice per year).
So we’ve effectively convinced ourselves that CAKE can survive the short term squeeze, but what about the long term. Here the story gets even better. With the current store count the core Cheesecake Factory franchise should easily be able to grow to 300 restaurants, possibly as many as 400. The Grand Lux concept seems to be doing well, and if successful could potentially support another 200-300 stores. The RockSugar concept is a complete question mark – but potential bonus – at this point. I’m impressed with two things regarding CAKE’s expansion. First, they seem very methodical about rolling out their new stores; focusing on finding and developing the best locations and not biting off more than they can chew. Secondly, I like the fact that they are developing new concepts before the current concept has matured. Too many companies just push (rapidly) the expansion of one concept without knowing where the next phase of growth will come from.
That’s it for today’s entry. Next time, we’ll look at valuation for Cheesecake Factory to see if the current price represents a good investment.
Click here for Part II
Overview:
The Cheesecake Factory operates 139 (as of April, 2008) Cheesecake Factory restaurants described as “upscale, full-service, casual dining restaurants” in their SEC filings. Additionally they operate 13 Grand Lux Café’s and opened their first RockSugar Pan Asian Kitchen (don’t you just LOVE that name…) in LA. The Cheesecake Factory was started in 1972 by Oscar and Evelyn Overton. They opened their first restaurant in Beverly Hills in 1978 with the help of their son David. Today David Overton is the Chairman and CEO. He currently owns over 5% of the outstanding shares (3.7 million shares of 67 million) worth about $45 million.
The Common Sense Test:
I like to see if I an investment thesis passes muster from just a common sense stand point. So, how about CAKE? Well, they certainly operate in a tasty and understandable operating segment. They’ve grown their revenue nicely over the last 10 years at about a 22-25% clip. I’ve eaten there and found the food delicious and interesting. The restaurants are always packed (although I’ve never eaten at a Grand Lux – let me know if you have, I’d be interested in your opinion). We’ll get more into valuation in a minute, but one of the things that attracted me to the stock has been its significant drop in price. It’s now trading in a range not seen since Feb-April 2000. Just for grins, I looked at their annual report from year ending 1999. At that time, they operated 34 total restaurants and had revenues of $347 million. As of yearend 2007, they had 153 restaurants and $1.5 billion in revenue. Yet now they trade for the same split adjusted price per share. From a common sense standpoint, it certainly seems as if the business value should be significantly higher today than eight years ago.
Investment Thesis – Bear Case
Whenever I look at an investment – particularly when I look at contrarian investments (which I do a lot, I like to buy things on sale) – I try to understand the bear case first. Sometimes it helps to be a cynic. It also helps to try to understand why someone is willing to sell, hey, they might be right at the end of the day.
For the Factory, the bear case seems straightforward – it’s really a matter of the one-two punch anyone in the consumer discretionary arena is dealing with today. Lowered consumer spending and sentiment driven by the credit crisis and gas prices (one, ouch) coupled with higher input costs due to commodity inflation, particularly food (two, ouch ouch). Normally, I’d look for signs that there are operational issues here, but that doesn’t seem to be the case, management seems competent and well motivated and Mr. Overton is certainly aligned with shareholders given his monetary investment in the company. The prevailing expectation seems to be that CAKE’s margins will get squeezed due to lower revenues as people pull back their spending and increased ingredient cost due to commodity inflation. Additionally, CAKE has always been debt free, but recently took on $275 million in debt, primarily to fund share repurchases.
The Bull Case
While I think the outlook for the Bear case is accurate, and I don’t see much chance of CAKE escaping the short term margins squeeze, I think the long term case for the company might be much better. Management seems cognizant of the short term challenges and intent on addressing them. They have reduced the number of store openings this year to 8-9 v. 21 store openings in 2007. They plan to funnel the cash freed up to repurchase shares – and when management repurchases shares, it’s a pretty good indication that they feel the price is undervalued.
As to the margin impact, current operating margins are good but not stellar. For example, the operating margin for CAKE runs about 7% against an industry average of 5%. Competitors such as Darden’s and Brinker’s sport operating margins in the high 7% range. While CAKE isn’t best in class (yet), it seem far enough ahead of the pack that they should be able to survive the short term margin squeeze they are living through at the moment. One thing that makes me confident in CAKE’s ability to do this is their potential pricing power. If you have been to Cheesecake Factory, you might be surprised to see the length of the line on a Friday or Saturday. They typically run at 95% and upwards of peak capacity – this is a popular concept. In fact, not long ago (when times were better) I read a negative review by an analyst panning the stock because at 95% capacity, they had little likelihood of driving comparable store sales growth! The point being, when you have a devoted following, you will be able to pass the costs along to the customer. The lag between rising costs and the timing to effectively raise menu prices guarantees that you will reduce your margin in a rising cost environment. However, I expect that CAKE will be able to pass along cost increases to their customers when they update their menus (which they do twice per year).
So we’ve effectively convinced ourselves that CAKE can survive the short term squeeze, but what about the long term. Here the story gets even better. With the current store count the core Cheesecake Factory franchise should easily be able to grow to 300 restaurants, possibly as many as 400. The Grand Lux concept seems to be doing well, and if successful could potentially support another 200-300 stores. The RockSugar concept is a complete question mark – but potential bonus – at this point. I’m impressed with two things regarding CAKE’s expansion. First, they seem very methodical about rolling out their new stores; focusing on finding and developing the best locations and not biting off more than they can chew. Secondly, I like the fact that they are developing new concepts before the current concept has matured. Too many companies just push (rapidly) the expansion of one concept without knowing where the next phase of growth will come from.
That’s it for today’s entry. Next time, we’ll look at valuation for Cheesecake Factory to see if the current price represents a good investment.
Click here for Part II
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