2023-07-15 01:27:58 ET
Summary
- The Cheesecake Factory is a well-positioned business with strong growth, but its margins are currently underperforming compared to its peers.
- The company's vast menu, focus on high-quality ingredients, and unique dining experience set it apart from competitors, but it faces challenges from the rise of online food delivery platforms.
- Compared to peers, CAKE is underperforming, primarily due to its profitability.
- Despite its commercial strength, CAKE's current valuation is unjustified due to its weaker financial position compared to pre-pandemic levels.
Investment thesis
Our current investment thesis is:
- CAKE is a well-positioned business due to its attractive commercial profile, offering consumers a unique dining experience that is resilient against changing industry dynamics.
- Growth has been strong, with the expectation for this to continue as new locations are opened and consumers continue to enjoy its service.
- Margins are problematic but improvement looks likely. CAKE is currently underperforming its peers and based on its relative valuation, does not suggest upside.
Company description
The Cheesecake Factory (CAKE) is a renowned American restaurant company known for its extensive menu, including a wide variety of appetizers, entrees, and, of course, delectable cheesecakes. The company operates over 200 restaurants across the United States and internationally.
Share price
CAKE's share price has significantly underperformed the market, partially due to the impact of Covid-19 but also as a result of its mild performance thus far. The company has struggled to achieve consistent improvement despite increasing scale.
Financial analysis
CAKE's financials (Capital IQ)
Presented above is CAKE's financial performance for the last decade.
Revenue & Commercial Factors
CAKE's revenue has grown at a CAGR of 7% in the last 10 years, a respectable achievement given the level of competition in the market. During the historical period, growth has been relatively consistent, with only a single period of negative growth (excl. Covid-19), reflecting this positive trajectory.
Business Model
CAKE offers an expansive menu with a focus on high-quality ingredients, scratch-made recipes, and culinary creativity. This is part of the company's objective to provide guests with a memorable dining experience, in conjunction with its distinctive restaurant ambiance, attentive service, and attention to detail. This differentiates the business from many of its peers at a similar price point, who primarily focus on cuisine rather than atmosphere and environment. CAKE is able to efficiently provide consumers with both, representing an attractive dining experience.
CAKE regularly introduces new menu items and seasonal offerings to cater to evolving consumer tastes and preferences. This is a growing trend among other restaurants as they finally realize the benefit of such a strategy. This encourages recurring attendance while also broadening its reach to casual consumers shopping around.
Given the size of its menu and locations, the company emphasizes efficient restaurant operations, including standardized processes, inventory management, and staff training. This allows the business to maintain consistent quality and control costs, allowing it to maximize the experience provided to consumers.
In addition to The Cheesecake Factory, CAKE has diversified its brand portfolio through the acquisition of North Italia and Fox Restaurant Concepts, as well as operating other concepts such as Grand Lux Cafe, RockSugar Southeast Asian Kitchen, and Social Monk Asian Kitchen. Revenue is primarily generated from The Cheesecake Factory, but this provides some diversification benefits.
Revenue split (CAKE)
Footprint expansion represents a key opportunity of driving growth in the coming years. Management is planning to open 20-22 restaurants in FY23, with 2-3 overseas. Given the relatively small number of locations, especially overseas, we believe there is sufficient runway to continue to drive growth through this strategy.
Competitive Positioning
We believe CAKE's competitive advantage stems from the experience it provides to consumers. With a vast menu and culinary expertise, the company is able to set itself apart from competitors. Further, its focus on providing an enjoyable and distinctive dining experience contributes to customer loyalty and repeat visits, as the experience is considered enjoyable beyond just good food.
Restaurant Industry
Competitors in the dining industry differentiate themselves based on menu offerings (cuisine), price points, customer service, and restaurant ambiance. CAKE faces competition from casual dining chains like Olive Garden ( DRI ), Outback Steakhouse ( BLMN ), Chili's ( EAT ), Texas Roadhouse ( TXRH ), Chipotle ( CMG ), and Shake Shack ( SHAK ), as well as local and regional restaurant operators.
The restaurant industry is highly competitive, with new entrants and existing players vying for market share. This has contributed to a degree of harmonization in the industry, with businesses operating with a similar approach around the few most successful cuisines in the US. This is where CAKE differentiates itself we believe, as it is capable of severing several cuisines at a high-quality, while also focusing on differentiating its restaurant experience.
Increasing consumer demand for healthier food choices is forcing restaurants to innovate, seeking the inclusion of high-quality and tasty food options that are lighter, plant-based, and gluten-free. This leans perfectly into CAKE's large menu approach, allowing the business to seamlessly adapt and continue to appeal to a large customer base.
The rise of online food delivery platforms due to the value provided by convenience has materially disrupted the restaurant industry. This has contributed to fewer consumers seeking out restaurants, as they do not believe there is sufficient value offered to eat in-store. The concern with this is that the economics from delivery sales are far lower than in-store, destroying value (as the following illustrates).
Restaurant economics (McKinsey / Edison Trends / National Restaurant Association)
We believe CAKE is positioned well to maintain strong attendance due to the experience provided, but it is still facing issues with responding to this development. We believe this will act as a downward pressure on margins, while the increased competition due to more options could also impact demand.
Economic & External Consideration
Current economic conditions represent a short-term risk to the business, as high inflation and elevated rates encourage consumers to tighten finances, reducing discretionary spending.
According to a research analyst at Datassential, "I think operators are still hopeful for a good summer boon in foot traffic and sales ... but I think on the consumer side, they're more hesitant"
Thus far, CAKE has remained robust, with YoY growth of 9%, 6% of which was comparable growth. This implies resiliency thus far, although we continue to remain hesitant.
Margins
CAKE's margins are a clear weakness for the business, with an EBITDA-M of 5% and a NIM of 1%. This is substantially below its pre-Covid level, where the business boasted an EBITDA-M of 10-12%.
The margin reduction is a reflection of inflationary pressures, with the cost of food and wage inflation materially impacting the business. This is a reflection of why many large restaurant chains choose to franchise, as they can export the operational risk. Margins are improving, with OPM increasing by 0.3ppts YoY, however, the progress is slow. The concern is that CAKE will be unable to sufficiently win back margins as cost pressures subside.
Balance sheet & cash flows
CAKE's ND/EBITDA ratio is currently 4.2x, a high level but primarily relating to property leases. This level has scope to increase without concern, allowing the business to fund the new locations.
Although distributions have returned, they remain below the historical level, reflecting weaker profitability.
Outlook
Outlook (Capital IQ)
Presented above is Wall Street's consensus view on the coming 5 years.
Revenue is forecast to grow at a similar level to historically achieved, with an average rate of 8%. Given the commercial strength of the business, this looks reasonable.
Margins are forecast to improve, although will seemingly normalize at the 7% level. This is significantly below its prior level. This is a reasonable estimate given the developments thus far.
Industry analysis
Restaurant industry (Seeking Alpha)
Presented above is a comparison of CAKE's growth and profitability to the average of its industry, as defined by Seeking Alpha (38 companies).
CAKE's revenue growth is comparable to the industry, implying it has responded to the Covid-19 pandemic in line with the industry average. This said, the expectation is for growth to materially underperform in the coming year. This is likely a reflection of reduced restaurant attendance as economic conditions bite.
Margins-wise, CAKE significantly underperforms. This is a reflection of the superiority of its larger franchising peers, who are able to operate with lean operations. This said, the company is comparable on an efficiency basis, assuming a good allocation of resources (and returns per restaurant).
Based on this, we believe CAKE should trade at a discount to its peer group, at least 20%, reflecting its significantly weaker cash flow conversion.
Valuation
CAKE is currently trading at 19x LTM EBITDA and 13x NTM EBITDA. This is a premium to its historical average.
A premium to CAKE's historical average looks completely unjustified as, despite its commercial strength, the company is financially weaker than its pre-pandemic position. This premium is likely a reflection of investors pricing in margin improvement in the coming years, likely beyond the level forecast by Analysts.
Relative to its peer group, CAKE is trading at an LTM discount of 11% and a NTM FCF premium of 20%. This implies its weakness is somewhat priced in, but investors are quite bullish on the improvement in the coming 18-36 months.
Overall, we believe much of the upside is likely priced in as CAKE is trading at a slight premium to our expected fair value range.
Final thoughts
CAKE is a commercially impressive business in our view. The company has achieved diversification from its comparable restaurant peers, offering consumers a holistic restaurant experience. The industry is facing both tailwinds and headwinds, which we believe CAKE is positioned well to navigate. The biggest issue with the business is margins and it's currently uncertain where these will land in the coming years.
CAKE's valuation currently prices in the improvement we are expecting and so we rate the stock a hold until we have further visibility on margins.
For further details see:
The Cheesecake Factory: A Recipe For Success In The Competitive Restaurant Industry