CHEESECAKE FACTORY – UPDATED WRITE-UP

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CONCLUSION

Cheesecake Factory continues to set most of the standards among the full service casual dining restaurants, yet is subject to the operating challenges the entire industry faces: flat to down traffic, costs such as labor and rent rising, and too much competition for the consumer’s food dollar. The one time benefit from lower taxes allowed for an EPS increase during 2018 but pretax operating earnings have been down, and don’t promise to increase by much in 2019. CAKE, selling at 9.4x trailing EBITDA is not expensive but we don’t see a catalyst for much better operating performance, especially in an economy that is clearly slowing.

COMPANY OVERVIEW

The Cheesecake Factory concept originated in 1972 as a small bakery in Los Angeles, CA area. In 1978 it opened the first Cheesecake Factory restaurant in Beverly Hills, CA. As of September 2018, the Company operates 215 company owned restaurants: 199 Cheesecake Factory restaurants, 14 Grand Lux Cafe locations, and 2 RockSugar Southeast Asian Kitchen locations. In addition, there are 21 licensed locations worldwide of the Cheesecake Factory concept, with one more (Monterrey, Mexico) scheduled to open in Q1’19. Three additional company operated Cheesecake restaurants were expected to open in Q4’18. The first location of Social Monk Asian Kitchen, a newly developed fast casual concept, is expected to open in Q1’19. As of December 2017, Cheesecake had systemwide sales of $2.2 billion which was an increase of 1.8% over 2016. In 2016, CAKE invested $42M for a minority position in Fox Restaurant Concepts LLC, which operates North Italia and Flower Child, with further obligations to invest growth capital of $42M more over several years.

Cheesecake is among the best long-term performers in the Casual Dining space in several key areas. Cheesecake is ranked number one in AUV with annual sales of $10,700,000 and operating margins of 20.0% store level EBITDA in 2017 (producing somewhat less in ’18, and targeting $10.6M and 18% going forward). In contrast to many restaurant chains, Cheesecake prepares from scratch all menu items except desserts which are produced at their bakery facilities, one of their competitive strengths. In conjunction with making all menu items from scratch, they consistently use high quality fresh ingredients. Cheesecake regularly updates its ingredients and cooking methods to adapt to consumer changes in taste; thus, their menu is always evolving.

Cheesecake places significant emphasis on contemporary interior design and décor. This creates a high energy ambiance in a Casual Dining setting and contributes to their distinctive dining experience. Dining Rooms feature large open-space areas and focus on efficient and friendly service. As a result, Cheesecake appeals to a diverse clientele across a broad demographic range and is classified as a Polished Casual Dining concept.

All menu items are available for take-out which represented 12% of sales in 2017, 13.5% most recently. Cheesecake partners with third party providers for delivery service, most prominently now using Doordash.  Additionally, Cheesecake has implemented online ordering for To-Go sales.

Cheesecake’s dessert menu line offers unique opportunities for add-on sales which as of December 2017 represented 16% of total restaurant sales. Their current menu features 50 varieties of their proprietary cheesecakes. The Company’s bakery division operates two bakery production facilities – one in Calabasas Hills, CA and the other in Rocky Mount, NC.

Grand Lux Cafe concept is Cheesecake’s upscale Casual Dining concept that offers globally inspired cuisine with an ambiance of modern sophistication. Grand Lux Cafe has 13 locations and offers classic American dishes and international favorites. Each Grand Lux Cafe has an on-site bakery and a full service bar. The average check is approximately $22.10.

RockSugar Southeast Asian Kitchen is Cheesecake’s Asian cuisine concept featuring an Asian menu and design elements in an upscale Casual Dining setting.

Consumer Packaged Goods – Given the strong affinity for the Cheesecake brand, the Company is leveraging opportunities in the consumer packaged goods channel. In 2017 Cheesecake partnered with a third party manufacturer to introduce branded cookies, cupcakes and cheesecake mixes as well as a line of confections marketed under the Cheesecake Factory at Home trademark in a variety of retail stores.

LONG-TERM GROWTH STRATEGY

Cheesecake’s growth strategy is based on selectively pursuing a variety of means to leverage their competitive strengths; including investing in or acquiring new restaurant concepts (such as Fox’s North India and Flower Child), expanding the Cheesecake Factory brand to other retail opportunities through the Cheesecake Factory at Home consumer package goods and internally developing a Fast Casual concept.

Their strategy is driven by their commitment to customer satisfaction and is focused primarily on menu innovation, service and operational execution that differentiates them from other restaurant concepts. While continuing to focus on customer satisfaction, CAKE is also driven by prudent management of expenses at their restaurants, bakery facilities and corporate support center and leveraging their size to make the best use of  purchasing power.

A large part of Cheesecake’s growth strategy is new company-owned restaurant development, the top priority for capital allocation. Cheesecake focuses on opening new stores in premier locations in the U.S. and Canada. Management targets an average cash on cash return of approximately 20% to 25% at the unit level. Cheesecake’s revenue growth strategy is to increase comparable restaurant sales by growing average check and stabilizing customer traffic through: (1) Continuing to offer innovative, high quality menu items that offer the customers a wide range of options in terms of flavor, price and value; (2) Focusing on service and hospitality with the goal of delivering an exceptional customer experience. Currently, management is working on a number of initiatives including third party delivery, increasing throughput, and leveraging the success of their gift card program, enhancing their training programs, and online ordering process. Current plans are to open about 6 company locations per year, which could be expanded to about 20 units per year, including Grand Lux, Rock Sugar, Social Monk, and the two Fox concepts.

It is thought that long term comp sales growth of 1-2% combined with unit growth of 5% can produce 6-7% top line growth. The targeted model provides total revenues of $3B in 2021, corporate margin after tax of 6%, and EPS of $4.50 per share by 2023. Focus on its people – development, engagement, and retention continue to be an intricate part of their growth strategy. A tribute to this is seen in their being listed (for the fifth year in a row) as one of Fortune Magazine’s 100 top best companies to work for.

UNIT LEVEL ECONOMICS (2017 10-K)

The relatively high sales productivity of Cheesecake restaurants provides opportunities to obtain competitive leasing terms from landlords. This aids in creating a strong store level EBITDA. Average unit sales per locations were approximately $10.6 million for fiscal 2017 and $10.7 million for 2016. Average sales per square foot was $962.

In selecting sites, Cheesecake’s current objective is to earn an appropriate ROI and restaurant level EBITDA of 18%. Their goal is to achieve an average return of approximately 20% to 25% for new restaurants. Average cash on cash return for restaurants opened at least 52 weeks was 27% in 2017, 31% in 2016, and 31% in 2015. ROIC was 15% in 2017, 17% in 2016, and 16% in 2015.

SHAREHOLDER RETURN

Cheesecake historically generates significant amounts of free cash flow. They utilize substantially all of their free cash flow for dividends and share repurchase. The latter of which affects dilution from equity compensation programs and supports their earnings per share growth. Year to date through Q3’18, $1.2 million shares had been purchased, for $60.9M. The quarterly cash dividend of $0.33 per share currently provides an annual yield of about 3%. The common stock (over the last several years) has traded in a broad range between $40 and $65 per share. Longer term, the stock is up substantially from a mid to high single digit range in ’08-’09 and low single digits in the early 90s.

RECENT DEVELOPMENTS (Q3’18 EARNINGS REPORT AND CONFERENCE CALL)

Cheesecake Factory reported a respectable third quarter, consistent with the industry pressures experienced by all operators. Comps were up 1.5%, not enough to offset expense increases. (Grand Lux comps were down 3.1%) Cost of sales was up 10 bp to 23.0%, Labor expenses was up 30 bp to 35.2%, Other Operating Expenses were down 10 bp to 24.8%, G&A was up 10 bp to 6.5%. Interest expense doubled, by 30 bp to 0.6%, leaving pretax income down 70 bp to 5.2%. A lower tax rate (5.7% vs. 19.2%) bailed out the EPS comparison. Pricing in the quarter was 2.9%, mix was a positive 0.6%, and traffic was down 2%, penalized by half of that by the timing of the National Cheesecake Day promotion.

Commentary on the conference call indicated that the wage inflation moderated from earlier in the year and medical costs normalized. Off premise business grew to 13.5% of sales, with the online ordering platform helping. Doordash is being used for delivery. Q4 guidance was provided, including comp sales of 0.5-1.5% at Cheesecake restaurants, diluted EPS of $0.60-$0.64 after a tax rate of 10%. Full year comps will be about 1.5%, EPS at $2.42-$2.46 with a 10% tax rate. Total capex in 2018 will be $80-85M, inclusive of five CAKE openings and $25M invested in the two Fox Restaurant concepts. Capex in 2019 will be $100-100M (6-8 openings), including $20-25M into Fox prior to the potential acquisition in late 2019 of North Italia (within Fox).

Relative to delivery, it is thought that it is 70% incremental. Off premise, at 13.5% of sales, compares to 12% in ’17, and delivery is about 25% of that, phone ordering is about 2/3, and the new online ordering platform generates 10-12% of all of the off premise business.

Management is guiding to flat store level margins in ’19, expecting that wage inflation will moderate somewhat, comps will be up adequately to offset small expense increases. There was no indication on the conference call, as of October 30th, that traffic or sales trends had changed since the end of Q3.

Conclusion: Provided at beginning of this article

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