CHEESECAKE FACTORY (CAKE) ANNOUNCES MAJOR ACQUISITION – A GOOD DEAL ??

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CHEESECAKE FACTORY ANNOUNCES MAJOR ACQUISITION – A GOOD DEAL ??

Late last week, Cheesecake announced second quarter earnings, not shocking in that comps were up a touch (1%), traffic was down a little (2.8%), cost of sales and labor were well controlled, down 20 bp and up only 20 bp respectively. G&A was 90 bp lower, allowing for a good EPS comparison. Basically, the historical quarter was more of the same.

Other than noting management’s expectation of continued 1-1.5% comp growth, 2% higher commodity prices and 6% higher wages during the rest of ’19, we would rather focus on the major acquisition that was announced.

THE ACQUISITION – THE PRESENTATION

CAKE has provided the investment community with a presentation regarding the planned acquisition of Fox Restaurant Concepts, for which they will pay $308M plus $88M previously invested pus $45M of cash over the next four years. This total of $440M is 1.1x the projected run rate ($400M) at the close of the transaction in late Q3. The acquisition provides for 100% of two growth vehicles developed by Fox Restaurant Concepts (North Italia and Flower Child) that CAKE had previously invested in, as well as full ownership of Fox’s other concepts.

The 20 current North Italia units are doing $7M per unit, and the 22 units will be doing about $150M at the close of the transaction. North Italia, 5,000-6,500 square feet in size, with an average check of $25-30, had comp sales of 5% in ’18, up mid-single-digit in ’19. They cost $3-3.5M of capex plus 12% of AUV (or 840k) in pre-opening expense. As described in the presentation: store level targeted EBITDA in year three is 18-20%, which would generate a 35%+ cash on cash return (excluding pre-opening expense). There can be, potentially, 200 North Italia locations in the US. Annual unit growth is projected at 20%. On the conference call, management indicated that in ’20 North Italia should have a store level EBITDA of about 17%, Fox as a whole at 15.5%. The growth of 20% in units at North Italia should provide an incremental 2 points at CAKE.

Fox Restaurant Concepts, including Flower Child and aside from North Italia, generate about $1,000/square foot, have a targeted EBITDA store level return of 16-18% in year three, have capex per square foot of $500/square foot, and have a targeted cash on cash return of 25-30%. Annual unit growth is projected at 20%. It is expected that the 20% unit growth at FRC will also add about 2 points to Cheesecake’s plan of 3% unit growth. The total acquisition is expected to be earnings neutral in 2020, accretive after that.

OUR INTERPRETATION

Best we can tell from the slide presentation and management’s comments, the concepts other than North Italia will be generating revenues about $250M by closing. The run rate of $400M by the end of Q3’19 will grow to $450M of sales in 2020. Between heavy pre-opening expenses and the inefficiency of new locations, it is not surprising that an earnings contribution will not occur until 2021.

CAKE’s presentation indicates the targeted sales/unit, the restaurant level EBITDA, the cash on cash returns and the sales/investment ratio for the Fox Restaurant Concepts (including Flower Child) vs. those at North Italia. Though the sales per square foot ($1,000 vs. $1,250), the targeted restaurant level margins (16-18% vs. 18-20%), the cash on cash returns (25-30% vs 35%+) are all materially lower at Fox (including Flower Child) vs North Italia, the profitability parameters at Fox are still impressive.

CONCLUSION

The appeal of the FRC acquisition lies with the high sales per square foot of North Italia and (probably) Flower Child, and the expectation that operating margins can be improved to provide attractive cash on cash returns. While normally we view targeted returns as suspect, Cheesecake Factory has a long and distinguished history of operating high volume restaurants with a very broad menu while controlling costs well and generating high returns on invested capital. The sales per square foot at North Italia are about the highest in the multi-unit casual dining industry, rivaling those at their new parent. If anyone can convert those sales to an appropriately high return on invested capital, it would be CAKE management. Unit growth at CAKE can grow from 3% annually to 6% or more, and operating margins, overall, could improve over time. We conclude that this acquisition will likely generate an attractive cash on cash return at both the restaurant and corporate level, and allow for better growth at CAKE in sales, cash flow from operations and earnings per share than we have seen in recent years.

Roger Lipton

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