CHEESECAKE FACTORY (CAKE) – STOCK RECOVERED NEAR PRE-PANDEMIC LEVEL – WHAT TO DO?

We published an analysis on October 22nd, showing almost all the publicly held restaurant companies, comparing their current valuations to those before the pandemic. That chart is provided below, with prices updated to midday on 11/17. Based on the 2/15/20 (pre-pandemic) estimate of 2020 earnings, and today’s estimate of 2021 earnings, it appears that Cheesecake Factory (CAKE) is substantially overvalued, which suggests that CAKE is somehow in a much better fundamental position coming out of the pandemic than going in. The stock is within 10% of its high, but the current consensus estimate for 2021 of $1.58 per share is very much below 2019 results and expectations back in February.

Let’s take a fundamental look at CAKE. Back on February 15th, CAKE was selling at about $41/share, with earnings expected in calendar 2020 in the area of $2.85/share. Trailing EPS, for calendar 2019, had been $2.61/share. This premier operator of large box restaurants (206 CAKE restaurants at 12/31/19, with 39 in CA, 19 in FL, 16 in TX) averaging over $10M per unit (almost 1,000/sq.ft.  has had several years of relatively flat operating results. Comp sales, as shown just below, have been slightly positive, with traffic, adjusting for price, slightly negative:

The table below, from Bloomberg LP, shows the historical EPS trend, as well as the current 2021 consensus EPS estimate, obviously still restrained from working through the pandemic burden.

It should be noted that while Cheesecake Factory Restaurants are the heart of this business, CAKE operates an additional 88 restaurants under the names North Italia, Grand Lux Cafe, Rock Sugar, Social Monk Asian Kitchen and Flower Child.   CAKE also operates two bakery facilities that supply their own restaurants as well as third party customers.  As you can see from the summary financials below, Income From Operations declined over the five years ending 12/19, from $165M to $106M. However, the steady cash flow from operations, combined with an increase of $200M of long term debt (to $290M) allowed the Company to shrink the fully diluted shares outstanding from 50.6M to 44.5M. This process, along with a lower tax rate, allowed earnings per share to do better than Income From Operations or Pretax Earnings.

In addition to the summary results just above, it is relevant that, between 2017 and 2019, Cost of sales was reduced by 40 bp to 22.6% of sales, Labor increased 190bp to 36.3%, Other Operating Costs increased by 110bp. Income From Operations decreased 260 bp to 4.2%, obviously reflecting the deterioration in store level margins.

Having pointed out the above lackluster sales trends and deteriorating profit margins, it cannot be ignored that CAKE restaurants serve the broadest menu in the industry, provide an outstanding value of food and service, and consistently receive very high marks in terms of customer satisfaction. Sales of just below $1000 per square foot are unmatched by any large scale casual dining chain. The Brand’s reputation, in the eyes of customers, is far from diminished.

THE CURRENT SITUATION

In terms of cash flow in 2020 and the current balance sheet : the Company took the necessary steps during the heart of the pandemic to assure adequate liquidity. Between 12/31/2019 and 9/29/20, cash increased from $58M to $243M (an increase of $185M, supplied by $200 of convertible preferred stock and an $86M increase in long term debt to $376M).  Cash Generated By Operating Activities  in the thirty nine weeks was a negative  $33M. Management indicated on the conference call that $96M was repaid on the credit line in October out of the 9/29 cash balance, bringing the long term debt balance back to $290M.

Same store sales at Cheesecake Restaurants were down 23.3% in Q3, a lot better than the 56.9% decline of Q2. There was a Loss from Operations of $34.9M, much better than the $83.7M of Q2.  Store level EBITDA margin of 7.8% was also much better than the negative 7.0% of Q2. Most importantly, comps improved sequentially throughout the quarter, from down 32% in July to negative 10% in September, and  running through October 27th at a negative 7%. There are lots of operating details we could provide, but the most important takeaway seems to be that the off-premise effort has apparently been retained even as dining rooms have reopened. Management expressed their confidence that this enlarged off-premise effort can be largely sustained, and the 35% flow through of cash from the incremental Q2 to Q3 sales can be sustained as sales build further. Management guided on the conference call to positive operating profit in Q4, with positive EPS after a 10% tax rate. Looking toward 2021, management indicated that commodity inflation would be about 2%, and wage rate inflation might not be quite as difficult as in recent years. Overall, management seemed to hold out hope that store level margins could be back to pre-pandemic levels (approximately double the 7.8% of Q3),  even at something just short of matching year ago sales (a 95% comp). This seems to be based on their confidence that off-premise sales can be maintained, better margins can be produced by call-in and online ordering (more than offsetting lower margins for deliveries) and labor inflation will be 1-1.5%, rather than the recent 5.5-6.0% annual increase. While we can’t forget that 18% of the Cheesecake restaurants are in lockdown challenged CA, that’s been the case already in the reported numbers and presumably included in management guidance.

CONCLUSION:

Putting it all together, we believe Cheesecake’s fundamentals are within reach (a year or so) of achieving pre-pandemic sales and margins. A large part of our consideration is the newly built satisfaction level of off-premise customers. We also consider that CAKE is in a class by themselves in terms of providing a very broad menu of well prepared food at compelling prices. We don’t doubt that their packaging and service, off premise,  is among the best within casual dining, and the possibility exists that off-premise can be largely sustained even as dine-in rebuilds. It therefore wouldn’t be shocking if two years from now, the AUVs are 10-20% higher than just before the pandemic, and operating margins could return to levels well above 2018 and 2019. Considering that the recovery is well established, CAKE’s operating skills are second to none, and an important new venue is now available to be served from existing facilities, CAKE shares are reasonably priced relative to their peer group.

Roger Lipton