2023-07-03 07:13:03 ET
Summary
- Cheesecake Factory shows potential for margin expansion in 2H23 due to price increases and a potential leveling off of cost inflation, which could lead to a rerating of the stock.
- Despite challenging weather conditions and tough year-over-year comparisons, CAKE achieved a 5.7% same-store sales increase, demonstrating consumer willingness to pay and indicating customer loyalty.
- The company's current valuation is lower compared to pre-COVID levels and its peers in the food and beverage industry, suggesting a potential upside for the stock.
Description
More than 200 of the restaurants owned and operated by The Cheesecake Factory ( CAKE ) are named after the Cheesecake Factory brand. I previously recommended a hold rating as I expect cost inflation to be a drag on margins, and that CAKE is not able to raise prices enough to keep up. However, I now do see some positive signs in the CAKE potential for margin expansion in 2H23. This should happen if CAKE continues to implement price increases (as it has done so) and cost inflation begins to level off. I believe this would be the catalyst for CAKE stock to rerate in 2H23. Beyond FY23, I think investors will start focusing back on the store developments (current focus is on pricing as investors look to management to raise prices to combat cost inflation), which is a deciding factor in CAKE long-term growth algorithm in my opinion. Importantly, store development must be done profitably and sustainably. As such, I think the right action here is to only go long if 2H23 margins starts picking up as expected, and size up when CAKE Is demonstrates that it is able to grow profitably beyond FY23 (supported by growth in store counts).
Store performance
Although I think SSS could have benefited from some enhancements, it certainly could have been worse. CAKE has accomplished a lot by printing 5.7% SSS despite the bad weather in California and in comparison to the tough comp last year. Most notably, CAKE demonstrated that a 10% price increase would not significantly reduce volume (-1%). The former is significant because it reveals consumers' willingness to pay; this is particularly relevant given that desserts, like the kind sold by CAKE, are a purely optional part of the diet. For me, the three main meals of the day (breakfast, lunch, and dinner) are mandatory, while dessert is purely optional and does not count toward my daily protein quota. As such, this does indicate that these customers really like CAKE. I expect management to continue this price increase strategy for this year as cost inflation is unlikely to subside so quickly given how the economy is behaving.
Margins
A major shift has occurred in CAKE's restaurant level margin (now 12% vs. FY21 (excluding 2Q21) and FY22) levels. If CAKE keeps its prices where they are now and inflation begins to decline in the coming quarters, I think the company's gross and earnings margins could grow even further. Remember that the supply chain problems (for food materials) and the hot labor market have had a significant impact on the bulk of CAKE's cost structure: food and labor. I anticipate very high incremental margins for CAKE in those 1-2 quarters due to timing differences when the two of them reverse course together with a higher price point. For reference, CAKE use to have net margin of mid-single digits, and is now at 3.8% on a LTM basis. I expect the improve restaurant level margins to translate directly to an improvement in net margins, driving it back to historical levels. I agree that it is difficult to predict the macro direction, but this could cause a surge in stock prices if margin expansion picks up speed.
Valuation
To be fair, I would say that CAKE valuation is not very demanding at the current valuation. The stock trades at 11x forward earnings, which is a lot lower than where it was pre-covid (range 14x to 20x). If we look at the pre-covid period, the business was growing at mid to high single digits, which consensus are expecting CAKE to grow at over the next 3 years as well. Profit margins profile are also expected to be similar. So, from a historical perspective, there is justification to say that CAKE should at least trade back to the mid-teens forward PE range. Comparing CAKE to other F&B peers (Cracker Barrel, Darden Restaurants, Denny's Corp, etc) that are trading at 14 to 18x forward earnings also suggest that CAKE Is trading at the lower end of the range. While I agree that CAKE competes in the less appealing part of the industry (desserts which has a lower TAM than other dayparts meal), the expected growth profile is similar over the near-term. Hence, I think the discount CAKE is trading at seems too high.
Risks
From my point of view, the key risk for CAKE is any shift in consumer preferences towards cheese cake as a dessert. The objective view is that CAKE primary offering is their wide choices of cheesecakes, and if consumer preference shifts away for other types of dessert, it would be a big hit to CAKE revenue and bottom line.
Summary
While maintaining a neutral stance on CAKE, there are positive indicators that make the valuation more appealing. The potential for margin expansion in the second half of 2023, driven by price increases and leveling off of cost inflation, could be a catalyst for the stock to rerate. Additionally, CAKE's ability to achieve a 5.7% same-store sales increase despite challenging weather conditions and tough year-over-year comparisons demonstrates consumer willingness to pay and indicates customer loyalty. The shift in restaurant-level margins and the expectation of high incremental margins in the coming quarters, coupled with a lower valuation compared to pre-COVID levels and peers in the food and beverage industry, suggest potential upside for CAKE.
For further details see:
The Cheesecake Factory: Remaining Neutral But Valuation Getting More Appealing