CHEESECAKE FACTORY INC CAKE S
August 15, 2016 - 9:26am EST by
maggie1002
2016 2017
Price: 51.11 EPS 2.75 2.97
Shares Out. (in M): 48 P/E 18.6 17.2
Market Cap (in M): 2,458 P/FCF 21 20
Net Debt (in M): -80 EBIT 184 0
TEV: 2,379 TEV/EBIT 13 0
Borrow Cost: General Collateral

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  • Restaurant
 

Description

I am recommending a short of The Cheesecake Factory (“CAKE” or the “Company”). 

According to the Company, The Cheesecake Factory created the upscale casual dining segment in 1978 with the introduction of its namesake concept.  For the namesake brand, the Company’s identity and reputation for offering high-quality desserts results in a substantially higher dessert mix, at ~16%, which consequently generated a higher average check at over $20 in the past two years.  The Company is among the most differentiated casual dining concepts and CAKE’s per unit sales, at over $10.5 M, is a leading metric among its peers.  The short thesis is partially predicated on an assertion that CAKE’s consecutive 26 quarter streak of positive same-store sales is likely “as good as it gets”.  And despite the per unit sales average being more than double that of a selected casual/specialty dining peer group, CAKE’s contribution margin is among the lowest across the peer group at more than a 15% discount to the peer average. 

As of February 25, 2016, the Company operated 201 Company-owned restaurants:  188 under the The Cheesecake Factory brand, 12 under the Grand Lux Café brand, and one under the RockSugar Pan Asian Kitchen brand.  Also, internationally there were eleven Cheesecake Factory branded units operating in the Middle East and Mexico under licensing agreements.  Management believes there is potential to grow the Cheesecake unit brand to 300 Company-owned and operated restaurants over time.  During fiscal years 2013-2015, the Company opened 29 units, including one Grand Lux Café in 2015, although the total openings included four relocations. 

During 2016, CAKE expects as many as eight units to open domestically.  As of now, two have been opened.  A critical ingredient to the Company’s expansion strategy is the development of a smaller format prototype (7,200 or 8,500 square feet versus 10,000 for a traditional Cheesecake location although existing units range from 5,000 to 21,000 of interior square feet).  Total costs are targeted at ~$800 per interior square foot and during 2015 the average sales per “productive” square foot was ~$967.  The most recent opening was in Greenville, SC and the next openings are scheduled in Queens, NY; Greensboro, NC; Stamford, CT; Valencia, CA; and Tacoma, WA.  I am dubious of CAKE’s ability to successfully drive the Cheesecake brand to 300 units.

The Grand Lux and RockSugar concepts have not been meaningful contributors and I believe that the Company’s initial drive of two other concepts is demonstrative of management’s perspective that the namesake brand will ultimately confront both unit and productivity growth challenges and therefore management deemed it prudent to drive other concepts that could supplement growth.  The Company opened its first Grand Lux Café in 1988 in Las Vegas.  During 2013, CAKE closed three Grand Lux Café units (in Beverly Hills, Denver, and Scottsdale), each of which had previously been fully impaired.  In fiscal 2015, the Company recorded a $6M impairment charge against the carrying value of RockSugar.      

CAKE operates in an increasingly challenged segment of the restaurant industry.  Casual dining growth has been dismal and there’s a low likelihood that such will improve substantially anytime soon.  Traffic at casual dining chains is down almost 30% since 2005.  During Q1 of 2015, CAKE realized its first traffic gain since 2012 but much of those 90 basis points were generated from both an earlier Easter and more benign winter across much of the country during Q1 2015. 

Two structural challenges include the fact that millennials favor fast casual concepts and the fact that the casual dining segment confronts traffic declines associated with the degradation of foot traffic across malls and shopping centers.  Despite the meaningful appreciation of the department store sector last week, which can be largely ascribed to both low expectations coupled with low valuation, the market has taken the department store sector to the woodshed for a variety of reasons but inclusive of challenges associated with mall-based traffic that is largely driven by the substitution effect from on-line commerce.  An analyst at CSFB recently shared an interesting observation regarding the close correlation of same-store sales at Nordstrom to The Cheesecake Factory.  From 2007-2013, a regression analysis comparing historical same-store sales data between the companies shows an R-value of 0.93; when comparing total sales, the R-value is still very high, at 0.89.

From 2008-2015, casual dining sales grew at just a 0.4% CAGR (per NPD Group 2015).  Over the same period, casual dining traffic fared worse, at a negative 1.9% CAGR.  Growing same store sales through traffic has become an increasing challenge and this is even more pronounced for dining establishments located at shopping malls and gallerias.  A significant majority of CAKE’s unit mix is located at shopping malls and gallerias.  CAKE’s comparable restaurant traffic has been negative during the past four quarters and the trend has deteriorated as evidenced during Q2 when traffic was down 2.7%. 

The Company recently delivered its 26th consecutive quarter of positive comparable sales (although at just 0.3%, short of the 0.6% consensus, and it was all pricing, at 2.9%, which I think will become an unsustainable benefit).  As the Company seeks to balance a desire to protect margin but also grow guest traffic, CAKE’s pricing will moderate during the second half of this year, at ~2.5% from 2.9%.

Traffic across the casual dining segment has also deteriorated because of the substantial increase in restaurant alternatives, primarily in the fast casual segment, as well as the relative attractiveness of eating “food at home” (FAH) and prepared foods from the grocery universe.  People are increasingly looking for convenience and lower-cost meals and this trend will likely continue to challenge the casual dining segment.

CAKE management recently acknowledged that growth across casual dining is “all about taking share, and it has been about taking share for a while.”  It should be little surprise that in this distorted environment of suppressed interest rates, the restaurant industry has witnessed numerous new entrants and some industry experts believe “sub-optimal location expansions” by legacy participants who might rationalize expanding with less discipline when “capital is free”.  The Company’s CFO recently said that “there is definitely more competition out there...grocery stores are now much more involved in competing for dining dollars…there’s definitely a lot of restaurants and a lot of options out there that just make taking share from others just a little bit more difficult.”  In short, competitive supply has escalated across the discretionary business of eating out. 

Declining traffic at CAKE has been and will likely continue to be a challenge.  Although CAKE has been able to overcome the traffic challenges with increased menu pricing, this is not likely a sustainable benefit.  Part of this short thesis is premised on a lower likelihood of increased pricing benefit relative to a higher likelihood of further labor cost escalation and the return of food cost inflation.

Within the casual dining segment, CAKE’s relative performance is attractive.  Over the past three years (2013-2015), CAKE’s same store sales averaged 1.6% which was more than double the casual dining peer group.  That said, in spite of the Company’s differentiated concept and strong execution, the Company generated only 0.3% in same-store sales during Q2 and management recently lowered its comp guidance to 1% (this is down from management’s 1.5-2.5% comp guidance earlier in the year).  At the beginning of 2016, management guided traffic being flat to down 1% but traffic is down considerably more.  The market has yet to discount the likelihood of continued traffic challenges and the unsustainability of pricing to drive a consistent increase in same-store sales.

A strong benefit for CAKE and the whole segment is that commodity costs remain generally favorable, particularly for proteins, wheat and dairy.  Commodity trends have provided a deflationary tailwind for the past year but the commodity tailwinds might not be a sustainable trend.  Since 2000, restaurant food costs have increased by an average of 3% and have not declined for two consecutive years.  With 2015 down 2% and 2016 trending downward, we will witness the first consecutive two-year decline since 2000.  However, industry experts agree that a third year of declining food costs is “highly unlikely” and “investors should not become overly complacent that a benign commodity environment is the new normal.” 

The Company garnered significant relief in cost of sales from 2011-2015 as evidenced by the 150 basis point improvement from 25.5% in 2011 to 24.0% in 2015.  Cost of sales will be even lower in 2016.  During Q2, cost of sales decreased by ~120 basis points from the prior year’s quarter to 22.7% and even management was pleasantly surprised as noted in their prepared comments that “versus our forecast, we captured additional food efficiency and the commodity environment was modestly more favorable that we had expected.”  William Blair’s earnings model now assumes that cost of sales in both 2016 and 2017 will be 23.1%; this is down 120 basis points from their model forecast one year ago.

While food costs have been declining, restaurant menu prices keep increasing.  Since 2000, menu price changes have, on average, been relatively flat with food price changes but that is not the case recently.  In 2015, the restaurant industry increased its menu price by 2.9% versus a decline of 2% in food costs.  This 4.9% difference is demonstrative of “food away from home” (FAFH) being more expensive relative to the “food at home” (FAH) alternative.  As of Q1, the difference was 5.8%.  The average spread since from 2000-2015 is 0.2% but restaurant menu inflation has outpaced grocery inflation by so much in the past year, the index (i.e., FAFH-FAH) is at a six-year peak.  The UDSA’s Economic Research Service is forecasting that FAH prices will increase by .25-1.25% in 2016.  This is well-below the twenty-year historical average of 2.5%.  Their forecast for 2017 is currently 1-2%. 

In general, grocers respond to increasing food costs by raising prices and they respond to decreasing costs by reducing prices.  When the disparity of price for FAFH grows relative to the alternative FAH, the restaurant industry has typically incurred traffic weakness.  This was evidenced last year when traffic was flat as well as during the first five months of 2016 when traffic was down 2.6%. 

There are some sell-side analysts that have characterized the restaurant industry softness that has recently been exhibited as a looming recessionary signal.  If a recession is likely in the near-term, then CAKE will confront other challenges I have not incorporated into my thesis.  My short thesis is not recession-driven and instead of ascribing the restaurant industry softness to a looming recession, I ascribe much of the weakness to increasing competitive supply, shopping center traffic weakness, and importantly the FAH alternative which is a better relative value for the consumer and increasingly so based on the six-year peak of FAFH less FAH.  Wendy’s CEO recently told investors that the widening gap between grocery and restaurant prices was the most notable reason for the recent softness in the fast food industry. 

Some might argue that eating at home is always a better “value” and that is generally true but people will always embrace going out to eat partially for the dining experience and for occasions.  However, when FAFH less FAH grows to the magnitude recently witnessed, historical traffic impacts occurred and it’s not likely to be different this time.  In fact, the evidence of declining traffic is clear and the adjustment that some restaurant operators have communicated, including CAKE, is to moderate menu pricing increases.  In the absence of the menu price increases already taken by the industry, margins would have been worse (assuming no change in traffic).  The Company and industry conundrum is whether traffic will improve with less menu price inflation.  That is the balance that CAKE is delicately trying to balance.  It’s also apparent across the vast majority of publicly-traded restaurant companies which have recently communicated an increasing level of value-driven promotional activity across QSR, fast casual, and casual dining.    

The restaurant industry is confronting structural issues associated with traffic and with labor, especially in the casual dining segment, but some have been able to garner improvements in margin in spite of these structural headwinds based on menu pricing and unit growth.  As noted, CAKE’s pricing during Q2 increased by 2.9% while traffic was down 2.7%.  The Company will be increasing pricing this summer but by 30-40 basis points less relative to last summer.  Management is trying to balance pricing, which will increasingly become an important lever against increased food costs and labor pressures in the future, and traffic which has been a struggle and I think largely a structural challenge.  It will be important to monitor any sustainable improvement in traffic that materializes as a result of a moderation of pricing.

The short thesis is partially predicated on traffic weakness that is deemed to be largely a structural issue and although it might improve somewhat with less menu price inflation, it will not be enough to compensate for the likelihood of increasing food and labor costs that compromise the margin improvements recently generated.  Although CAKE has admirably generated a consistency of same-store sales increases, at just 1% now expected this year and therefore an average of less than 1.6% from 2013-2016E, the Company can hardly be characterized as a “growth” stock and that is further reinforced by the current analyst consensus for 8% EPS growth from 2016 to 2017.  Furthermore, I envision that CAKE’s ability to sustain the consistency of same-store sales is likely at risk.  This is perhaps not a meaningful assertion with the most recent quarter at just 0.3% but an important point nonetheless as there are CAKE bulls that embrace the Company for its twenty six consecutive quarters of positive comparable sales.  When that headline is broken, I anticipate a likelihood of selling pressure.  I think the Company will likely confront a negative same-store sales headline in 2017.  More relevant is that assuming the assertion that same-store sales will go negative coupled with the assertion that commodity costs will not likely be an ongoing tailwind and that both of these issues will be compounded by labor cost pressures, CAKE will incur sales deleverage and a miss to earnings expectations during 2017.  For a stock that currently trades at over 18x this year’s estimated EPS for just 8% in EPS anticipated next year, the stock is not adequately discounting these noted issues.

The argument that food costs will likely rise in the future is not a near-term assertion.  In fact, since the Company has contracted 75% of its commodity basket, including 65% of the dairy basket, for the remainder of the year, bulls can feel confident that food costs will not be a headwind anytime this year.  Cream cheese and dairy comprise ~15% of CAKE’s commodity basket.  For 2016, cost of sales is anticipated to decline 70-80 basis points, an impressive improvement given the 80 basis point improvement in 2015.  With cost of sales approaching an all-time low for CAKE, I think the bulls are extrapolating such a trend that is unlikely to be sustainable nor favorable over time and this is not being adequately discounted as a risk in CAKE’s stock price. 

I am not trying to specifically forecast food costs but do believe in pattern recognition and since 1960, there has only been one other time that food costs declined (1990-1992) for two consecutive years.  There were no consecutive three year periods and although it is possible that 2017 marks the first three year period in over fifty-five years, we know that part of the reason that food costs will ultimately rise is that producers (note that farm net income is down by more than 50% in the past three years) adjust accordingly for their own business.  The UDSA’s Economic Research Service is forecasting that FAH prices will increase by 1-2% next year. 

There’s of course deflationary pressures around the world and that’s why Central Banks have been orchestrating an unprecedented magnitude of monetary stimulus and perhaps those deflationary challenges (a tailwind for restaurant food costs) will persist across food costs as well but what hasn’t changed is the fact that grocers adjusted their prices lower when food costs declined and when FAFH less FAH grows too high, restaurant traffic declines accordingly.  CAKE and its peers are wrestling with this challenge and have benefitted from lower food costs these past couple of years.  It might not be 2017 when those costs increase again but eventually those costs will increase (otherwise, there are other economic issues to incorporate into the short thesis) and the magnitude of pricing power to compensate for increasing food costs is likely to be mitigated by the acceleration of menu pricing that has recently been taken.

As the casual dining industry confronts sluggish same-store sales driven by a negative traffic trend, the restaurant industry also confronts workforce shortages and wage pressures.  An industry expert reported the “increasing difficulty in recruiting and hiring qualified employees and managers, and increasing wages.”  Escalating labor costs, reflecting both a tight labor market and government-mandated minimum wage increases in the Northeast, West Coast, and some major cities, are offsetting some of the benefit of low commodity costs.    

During Q2, labor was 33.2% of revenue, an increase of ~140 basis points from the prior year’s quarter (20 basis points more than the surprising magnitude of the decline in cost of sales for the quarter).  A majority of the increase was attributable to higher hourly wages.  Although wage rate inflation (at 5%) was in line with management’s expectations, CAKE did incur incremental impact from overtime.  Overall for 2016, management currently expects labor to be up 70-80 basis points, more than the 50 basis points that they initially anticipated.  Although the challenges of labor costs have become increasingly well-documented, I don’t think those issues, which are likely to escalate, are adequately discounted by CAKE’s investors.

From 2000-2015, the average restaurant wage increase was 3%, this is also equivalent to the average change in food costs over that period.  However, the average menu price change was less, at 2.8%.  It is this reversion to the mean that I envision will begin to materialize in the next 12-18 months.  When speaking with restaurant industry experts, they all communicate that it is “impossible” for the menu price change as well as potential menu mix benefits to “consistently” compensate for both increased wages and increased food costs.  A few of those with whom I conducted primary research are most anxious of years like 2007, 2008, and 2011 when food costs increased by 7.6%, 7.7%, and 8.0%, respectively, while restaurant wages increased by 6.3%, 3.8%, and 2.1%, respectively.  During those years, restaurant menu price changes ranged from 330 to 570 basis points below the food cost increase.  Since CAKE tries to mitigate food cost volatility through contracts, the Company’s margins didn’t suffer as much until the following years when the preceding year inflationary challenges materialized in their expense base.  During those following years, CAKE’s average operating margin was just 5.1% versus 7.7% for all other years from 2007-2015.

As one of the most labor-intensive companies within one of the most labor-intensive industries, CAKE’s exposure to wage inflation is a significant ongoing challenge that has mostly been buffered by menu pricing that I deem to be an unsustainable benefit.  In contrast to many casual dining chains, almost all of CAKE’s menu items, except those desserts manufactured at the Company’s bakery production facilities, are prepared daily at each unit.  This is among the Company’s notable competitive strengths.  However, the Company’s competitive positioning also makes CAKE a more labor-intensive business model.  Regardless of who lives in the White House this coming January, both the political momentum and populist movement will drive further minimum wage increases.  The employment environment has tightened which makes recruiting and retaining employees increasingly more difficult without the enticement of better compensation and CAKE is not only competing for talent with its peer group but also large national employers who have increased their minimum hourly wages materially above the Federal minimum wage of $7.25 to $9-10 per hour.  Furthermore, labor cost issues are particularly difficult in the state of California where CAKE has more than 15% of its units.  Some might argue that CAKE could drive towards improved labor productivity with a smaller staff and also through technology.  Management is strongly capable and has been implementing technology-driven productivity improvements including a mobile payment app, CakePay, which will be featured soon in a MasterCard commercial (free publicity benefit for CAKE) for its digital wallet solution MasterPass.  However, the notion of staff reductions (from ~170 per unit hourly staff) is not consistent with the high-touch guest experience that would be marginalized as it supposedly is core towards differentiating CAKE in the casual dining segment.

Labor costs will be an ongoing challenge for CAKE.  In addition to over 30% of states having already increased or scheduled an increase to the minimum wage in 2016, of which ten states have scheduled further increases in 2017 (including CA and NY where ~25% units are located) and six have further increases in 2018 (again including CA and NY), there are numerous large national employers (e.g., Costco, Target, Wal-Mart, TJX, GAP) who have voluntarily increased their wages, thereby heightening the competition for CAKE when recruiting and retaining employees. 

In California and New York, the minimum wage is expected to increase to $15 in the next few years.  Starting next year, the minimum wages in Connecticut and Massachusetts will rise to $10.10-11.00 per hour.  The average wage change of 3% since 2000 will be increasing and especially so in the current tighter employment scenario.  Furthermore, there is some risk to CAKE associated with the potential that tipping is eliminated.  Although this is unlikely a Federal mandate, we are witnessing some restaurant groups (most notably Danny Meyer’s Union Square Hospitality Group) eliminate tipping.  If this trend gains sufficient traction, it could marginalize the labor model of the casual dining segment.  CAKE and its peers benefit from customers paying a tip to their server.  The federal minimum wage for tipped employees is $2.13 per hour, but if an employee’s tips plus wage does not exceed $7.25 per hour, the restaurant owner will be fined.  In an environment of no tipping, the restaurant owner will incur more labor costs.  It is likely that restaurants would increase their menu pricing to compensate for this additional labor burden but having noted that pricing is among the reasons that restaurant traffic is struggling, this issue for CAKE would further escalate in an environment of no tipping. 

In addition to the labor cost issues ascribed to wages, CAKE will continue to confront healthcare cost challenges.  Since CAKE is self-insured, those issues can surface as much of a surprise as evidenced from results in Q4 of 2014.  Results that quarter missed consensus margin estimates by 140 basis points largely because of higher-than-expected medical claims.    During 2014, CAKE incurred a nearly 50% increase in high-cost claims (above $50,000), with the dollar amount of each high-cost claim more than 80% higher.  Within five days after the Company’s Q4 earnings announcement, the stock had declined by more than 10%.   

 The components of potential business growth are same store sales, margin, and unit growth.  For the reasons described, I think the growth potential for same store sales and margin are challenged.  In regards to unit growth, management targets new restaurant development that meets its return criteria to achieve a Company-level return of ~15%.  Average ROIC for the Company during 2013-2015 was 14-15%.  For new units, management targets an average return of ~20%.  During fiscal years 2013-2015, average fully capitalized cash return was 23-24% for The Cheesecake Factory restaurants in the Company’s comparable sales base.  As the Company focuses its expansion on smaller markets, I anticipate that the returns from new units are likely to be less attractive than historically and at $0.02-.03 of potential EPS per unit if successful, new unit growth, at the current valuation, will not adequately compensate for the likelihood of ongoing stagnation and potential decline of the existing base in the near-term. 

The consensus estimate, at $2.97, for EPS growth in 2017 is just 8%.  CAKE is currently trading at 18.6x this year’s EPS estimate and 17.2x next year’s estimate.  Relative to the peer group, CAKE’s 2017E P/E is ~5% premium to the peer median and ~5% discount to the peer average.  However, when CAKE’s valuation is compared to its peer group on the basis of EPS growth expected for next year, it is the second highest and almost a 60% premium to the peer median and ~55% premium to the peer average.  Although the challenges confronting the restaurant industry and specifically to the casual segment have recently become more well-documented (i.e., certainly a risk consideration), I anticipate those challenges will persist in the near-term and industry multiples are likely to compress with the likelihood of more misses and reduced guidance. 

I don’t envision the premium multiple accorded to CAKE’s lower growth expected next year as being sustainable and I think it’s unlikely that the peer group industry multiple expands.  To the extent that CAKE were accorded the same peer group multiple for next year’s growth on CAKE’s consensus estimate, CAKE would be trading at $33.  On a DCF basis assuming FCF were to ambitiously grow by 4% in each of the next ten years and applying a 10% discount rate, CAKE would trade at ~$36.     

Investors have not yet discounted the numerous challenges confronting CAKE.  The risks confronting CAKE include ongoing guest traffic struggles and a reversal from pricing benefits accorded to the six-year peak of FAFH less FAH.  The combination of these issues will likely lead to negative same-store sales and the inherent negative operating leverage that comes with it and especially as labor pressures escalate further. 

Since the public market restaurant industry investor is often focused on same-store sales and CAKE has generated twenty-six quarters of consecutive growth, I anticipate that when that metric goes negative, the market is likely to adjust CAKE’s valuation accordingly.  Even if I am wrong regarding this materializing next year at CAKE, industry-related challenges should pressure the peer group’s multiple and the premium (55-60%) accorded to CAKE’s EPS growth for next year, at less than half the peer average.  I think the recent evidence of restaurant industry issues is just the beginning of ongoing headwinds and that CAKE’s consistency of same-store sales growth will be halted in the near-term, thereby reinforcing structural challenges.  The market will therefore no longer accord CAKE a premium multiple for less expected growth and the stock will decline accordingly.  I envision CAKE generating a 20% return on the short side but am mindful of the risk considerations (some noted below) and have not sized this fully yet but deem the short an attractive risk-reward at the current price.

Risk Considerations

Among the risks of being short CAKE includes the following:

Management is strongly capable.  In the restaurant industry, one cannot discount the importance of execution and CAKE’s management is well-regarded for their methodical and detailed approach.  In 2015, The Cheesecake Factory was named for the second year in a row to Fortune magazine’s “100 Best Companies to Work For” list.

This year CAKE will benefit (by .05-.08) from an additional week of operations and that additional week is “a very good additional week”, said CAKE’s CFO Douglas Benn. Last year, the fourth quarter ended on December 29th which meant it excluded the strong New Year’s holiday.  This year, CAKE’s fourth quarter will end on January 3, 2017 and therefore the Company’s sales will have benefitted from two New Year’s eves in the same year.  That said, this will become another headwind for earnings potential growth during fiscal year 2017.

Expectations for restaurants in general and CAKE specifically have recently been lowered by downgrades at both Jefferies and Stifel.  The lower expectations of course might marginalize a short thesis if it becomes too well-documented.  Since I don’t receive research from either Jefferies or Stifel, I cannot opine on the all of the specific differences that I describe and those from the recent downgrades.  However, given the attention that those industry-wide downgrades received, there is some context reported by the general business news media.  Stifel’s downgrade is prompted by slowing restaurant sales being the “canary that lays the recessionary egg” and their belief that a recession will hit the U.S. in coming months.  Paul Westra wrote, “we confidently believe” that a recent Stifel survey showing restaurant sales decelerating “simultaneously” across all categories “is a harbinger to a U.S. recession in 2017” and “a prospective 2017 U.S. recession could be the worst ever for restaurants”.  On the same day, Andy Barish at Jefferies also downgraded multiple restaurant chains saying he was “calling the top of the restaurant cycle” after an “extensive” study suggested that the “industry has at least 18 months of challenges ahead” in terms of softer same-store sales and higher labor costs.  I have been working on the short thesis for several weeks and I would have preferred the absence of these downgrades because it inherently lowered market expectations.  My thesis is not predicated on a recession in the U.S. as Westra asserts but the overabundance of supply in the restaurant industry compounded by structural mall-based location challenges which has and is likely to continue creating traffic headwinds, and that the benefit accrued from a six-year peak in pricing relative to food costs is unsustainable. 

Given the Company’s challenge to drive additional growth through another concept (i.e., Grand Lux and Rock Sugar) and the inherent structural casual dining segment challenges, management is likely interested in developing or acquiring a fast-casual concept.  I recognize this as a risk consideration in the near-term and I suspect the market would applaud such a strategic move by management to supplement growth through acquisition and within this market presumably ignore much of the premium paid.  Furthermore, the restaurant industry woes, which has driven valuations of some publicly-traded concepts to significantly lower multiples versus CAKE, could provide attractive acquisitions that are immediately accretive.  In managing against this and other risks, I would adjust exposure to such news and price action accordingly with an eagerness to short more CAKE at higher levels.  Also, I would view such a strategic move as reinforcement of the short thesis in regards to CAKE’s structural issues in its core business. 

CAKE has spent substantially all its FCF on buybacks in the last three years and the Company maintains a sizeable buyback authorization to buffer a fundamental-driven decline.  The Company’s buyback has accounted for about one-third of EPS growth.

CAKE maintains a strong balance sheet and could expand its buyback activity to further support the stock although management has communicated an unwillingness to pursue leverage for such purposes.

CAKE’s international business remains small and offers a higher return per unit based on the royalty-driven arrangement.  Each international unit could contribute ~$0.01 to EPS.    

The Company recently raised its dividend, now $.96 on an annualized basis, and in this distorted/suppressed interest rate environment, the dividend could provide some downside support.  That said, there are publicly-traded restaurants with a much higher implied yield (e.g., DIN at almost 5%), so I don’t think the dividend is high enough to prevent the stock from ultimately declining to my target price.

An overarching risk consideration in this environment is the notion of shorting in general when price discovery is distorted by Central Bank activities.

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise do not hold a material investment in the issuer's securities.

Catalyst

Selected Catalysts

·         Negative traffic trends continue

·         Consistency of same-store sales is eclipsed

·         Margin erodes as caused by any combination of moderation of pricing, food cost inflation, and labor cost pressures escalating

·         Success and productivity of new units becomes questionable, thereby marginalizing CAKE’s ability to drive towards 300 unit goal

·         Valuation is re-rated to adjust for lower growth prospects

·         CAKE pays a substantial premium to acquire another concept to drive potential growth; market might react positively (i.e., inclined to short more) despite premium paid but such acquisition would reinforce confidence that core business is likely to struggle in near/medium-term (e.g., would remind me of Ruby Tuesday’s unsuccessful drive to diversify with Lime acquisition while ongoing struggles confronted their core brand)

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    Description

    I am recommending a short of The Cheesecake Factory (“CAKE” or the “Company”). 

    According to the Company, The Cheesecake Factory created the upscale casual dining segment in 1978 with the introduction of its namesake concept.  For the namesake brand, the Company’s identity and reputation for offering high-quality desserts results in a substantially higher dessert mix, at ~16%, which consequently generated a higher average check at over $20 in the past two years.  The Company is among the most differentiated casual dining concepts and CAKE’s per unit sales, at over $10.5 M, is a leading metric among its peers.  The short thesis is partially predicated on an assertion that CAKE’s consecutive 26 quarter streak of positive same-store sales is likely “as good as it gets”.  And despite the per unit sales average being more than double that of a selected casual/specialty dining peer group, CAKE’s contribution margin is among the lowest across the peer group at more than a 15% discount to the peer average. 

    As of February 25, 2016, the Company operated 201 Company-owned restaurants:  188 under the The Cheesecake Factory brand, 12 under the Grand Lux Café brand, and one under the RockSugar Pan Asian Kitchen brand.  Also, internationally there were eleven Cheesecake Factory branded units operating in the Middle East and Mexico under licensing agreements.  Management believes there is potential to grow the Cheesecake unit brand to 300 Company-owned and operated restaurants over time.  During fiscal years 2013-2015, the Company opened 29 units, including one Grand Lux Café in 2015, although the total openings included four relocations. 

    During 2016, CAKE expects as many as eight units to open domestically.  As of now, two have been opened.  A critical ingredient to the Company’s expansion strategy is the development of a smaller format prototype (7,200 or 8,500 square feet versus 10,000 for a traditional Cheesecake location although existing units range from 5,000 to 21,000 of interior square feet).  Total costs are targeted at ~$800 per interior square foot and during 2015 the average sales per “productive” square foot was ~$967.  The most recent opening was in Greenville, SC and the next openings are scheduled in Queens, NY; Greensboro, NC; Stamford, CT; Valencia, CA; and Tacoma, WA.  I am dubious of CAKE’s ability to successfully drive the Cheesecake brand to 300 units.

    The Grand Lux and RockSugar concepts have not been meaningful contributors and I believe that the Company’s initial drive of two other concepts is demonstrative of management’s perspective that the namesake brand will ultimately confront both unit and productivity growth challenges and therefore management deemed it prudent to drive other concepts that could supplement growth.  The Company opened its first Grand Lux Café in 1988 in Las Vegas.  During 2013, CAKE closed three Grand Lux Café units (in Beverly Hills, Denver, and Scottsdale), each of which had previously been fully impaired.  In fiscal 2015, the Company recorded a $6M impairment charge against the carrying value of RockSugar.      

    CAKE operates in an increasingly challenged segment of the restaurant industry.  Casual dining growth has been dismal and there’s a low likelihood that such will improve substantially anytime soon.  Traffic at casual dining chains is down almost 30% since 2005.  During Q1 of 2015, CAKE realized its first traffic gain since 2012 but much of those 90 basis points were generated from both an earlier Easter and more benign winter across much of the country during Q1 2015. 

    Two structural challenges include the fact that millennials favor fast casual concepts and the fact that the casual dining segment confronts traffic declines associated with the degradation of foot traffic across malls and shopping centers.  Despite the meaningful appreciation of the department store sector last week, which can be largely ascribed to both low expectations coupled with low valuation, the market has taken the department store sector to the woodshed for a variety of reasons but inclusive of challenges associated with mall-based traffic that is largely driven by the substitution effect from on-line commerce.  An analyst at CSFB recently shared an interesting observation regarding the close correlation of same-store sales at Nordstrom to The Cheesecake Factory.  From 2007-2013, a regression analysis comparing historical same-store sales data between the companies shows an R-value of 0.93; when comparing total sales, the R-value is still very high, at 0.89.

    From 2008-2015, casual dining sales grew at just a 0.4% CAGR (per NPD Group 2015).  Over the same period, casual dining traffic fared worse, at a negative 1.9% CAGR.  Growing same store sales through traffic has become an increasing challenge and this is even more pronounced for dining establishments located at shopping malls and gallerias.  A significant majority of CAKE’s unit mix is located at shopping malls and gallerias.  CAKE’s comparable restaurant traffic has been negative during the past four quarters and the trend has deteriorated as evidenced during Q2 when traffic was down 2.7%. 

    The Company recently delivered its 26th consecutive quarter of positive comparable sales (although at just 0.3%, short of the 0.6% consensus, and it was all pricing, at 2.9%, which I think will become an unsustainable benefit).  As the Company seeks to balance a desire to protect margin but also grow guest traffic, CAKE’s pricing will moderate during the second half of this year, at ~2.5% from 2.9%.

    Traffic across the casual dining segment has also deteriorated because of the substantial increase in restaurant alternatives, primarily in the fast casual segment, as well as the relative attractiveness of eating “food at home” (FAH) and prepared foods from the grocery universe.  People are increasingly looking for convenience and lower-cost meals and this trend will likely continue to challenge the casual dining segment.

    CAKE management recently acknowledged that growth across casual dining is “all about taking share, and it has been about taking share for a while.”  It should be little surprise that in this distorted environment of suppressed interest rates, the restaurant industry has witnessed numerous new entrants and some industry experts believe “sub-optimal location expansions” by legacy participants who might rationalize expanding with less discipline when “capital is free”.  The Company’s CFO recently said that “there is definitely more competition out there...grocery stores are now much more involved in competing for dining dollars…there’s definitely a lot of restaurants and a lot of options out there that just make taking share from others just a little bit more difficult.”  In short, competitive supply has escalated across the discretionary business of eating out. 

    Declining traffic at CAKE has been and will likely continue to be a challenge.  Although CAKE has been able to overcome the traffic challenges with increased menu pricing, this is not likely a sustainable benefit.  Part of this short thesis is premised on a lower likelihood of increased pricing benefit relative to a higher likelihood of further labor cost escalation and the return of food cost inflation.

    Within the casual dining segment, CAKE’s relative performance is attractive.  Over the past three years (2013-2015), CAKE’s same store sales averaged 1.6% which was more than double the casual dining peer group.  That said, in spite of the Company’s differentiated concept and strong execution, the Company generated only 0.3% in same-store sales during Q2 and management recently lowered its comp guidance to 1% (this is down from management’s 1.5-2.5% comp guidance earlier in the year).  At the beginning of 2016, management guided traffic being flat to down 1% but traffic is down considerably more.  The market has yet to discount the likelihood of continued traffic challenges and the unsustainability of pricing to drive a consistent increase in same-store sales.

    A strong benefit for CAKE and the whole segment is that commodity costs remain generally favorable, particularly for proteins, wheat and dairy.  Commodity trends have provided a deflationary tailwind for the past year but the commodity tailwinds might not be a sustainable trend.  Since 2000, restaurant food costs have increased by an average of 3% and have not declined for two consecutive years.  With 2015 down 2% and 2016 trending downward, we will witness the first consecutive two-year decline since 2000.  However, industry experts agree that a third year of declining food costs is “highly unlikely” and “investors should not become overly complacent that a benign commodity environment is the new normal.” 

    The Company garnered significant relief in cost of sales from 2011-2015 as evidenced by the 150 basis point improvement from 25.5% in 2011 to 24.0% in 2015.  Cost of sales will be even lower in 2016.  During Q2, cost of sales decreased by ~120 basis points from the prior year’s quarter to 22.7% and even management was pleasantly surprised as noted in their prepared comments that “versus our forecast, we captured additional food efficiency and the commodity environment was modestly more favorable that we had expected.”  William Blair’s earnings model now assumes that cost of sales in both 2016 and 2017 will be 23.1%; this is down 120 basis points from their model forecast one year ago.

    While food costs have been declining, restaurant menu prices keep increasing.  Since 2000, menu price changes have, on average, been relatively flat with food price changes but that is not the case recently.  In 2015, the restaurant industry increased its menu price by 2.9% versus a decline of 2% in food costs.  This 4.9% difference is demonstrative of “food away from home” (FAFH) being more expensive relative to the “food at home” (FAH) alternative.  As of Q1, the difference was 5.8%.  The average spread since from 2000-2015 is 0.2% but restaurant menu inflation has outpaced grocery inflation by so much in the past year, the index (i.e., FAFH-FAH) is at a six-year peak.  The UDSA’s Economic Research Service is forecasting that FAH prices will increase by .25-1.25% in 2016.  This is well-below the twenty-year historical average of 2.5%.  Their forecast for 2017 is currently 1-2%. 

    In general, grocers respond to increasing food costs by raising prices and they respond to decreasing costs by reducing prices.  When the disparity of price for FAFH grows relative to the alternative FAH, the restaurant industry has typically incurred traffic weakness.  This was evidenced last year when traffic was flat as well as during the first five months of 2016 when traffic was down 2.6%. 

    There are some sell-side analysts that have characterized the restaurant industry softness that has recently been exhibited as a looming recessionary signal.  If a recession is likely in the near-term, then CAKE will confront other challenges I have not incorporated into my thesis.  My short thesis is not recession-driven and instead of ascribing the restaurant industry softness to a looming recession, I ascribe much of the weakness to increasing competitive supply, shopping center traffic weakness, and importantly the FAH alternative which is a better relative value for the consumer and increasingly so based on the six-year peak of FAFH less FAH.  Wendy’s CEO recently told investors that the widening gap between grocery and restaurant prices was the most notable reason for the recent softness in the fast food industry. 

    Some might argue that eating at home is always a better “value” and that is generally true but people will always embrace going out to eat partially for the dining experience and for occasions.  However, when FAFH less FAH grows to the magnitude recently witnessed, historical traffic impacts occurred and it’s not likely to be different this time.  In fact, the evidence of declining traffic is clear and the adjustment that some restaurant operators have communicated, including CAKE, is to moderate menu pricing increases.  In the absence of the menu price increases already taken by the industry, margins would have been worse (assuming no change in traffic).  The Company and industry conundrum is whether traffic will improve with less menu price inflation.  That is the balance that CAKE is delicately trying to balance.  It’s also apparent across the vast majority of publicly-traded restaurant companies which have recently communicated an increasing level of value-driven promotional activity across QSR, fast casual, and casual dining.    

    The restaurant industry is confronting structural issues associated with traffic and with labor, especially in the casual dining segment, but some have been able to garner improvements in margin in spite of these structural headwinds based on menu pricing and unit growth.  As noted, CAKE’s pricing during Q2 increased by 2.9% while traffic was down 2.7%.  The Company will be increasing pricing this summer but by 30-40 basis points less relative to last summer.  Management is trying to balance pricing, which will increasingly become an important lever against increased food costs and labor pressures in the future, and traffic which has been a struggle and I think largely a structural challenge.  It will be important to monitor any sustainable improvement in traffic that materializes as a result of a moderation of pricing.

    The short thesis is partially predicated on traffic weakness that is deemed to be largely a structural issue and although it might improve somewhat with less menu price inflation, it will not be enough to compensate for the likelihood of increasing food and labor costs that compromise the margin improvements recently generated.  Although CAKE has admirably generated a consistency of same-store sales increases, at just 1% now expected this year and therefore an average of less than 1.6% from 2013-2016E, the Company can hardly be characterized as a “growth” stock and that is further reinforced by the current analyst consensus for 8% EPS growth from 2016 to 2017.  Furthermore, I envision that CAKE’s ability to sustain the consistency of same-store sales is likely at risk.  This is perhaps not a meaningful assertion with the most recent quarter at just 0.3% but an important point nonetheless as there are CAKE bulls that embrace the Company for its twenty six consecutive quarters of positive comparable sales.  When that headline is broken, I anticipate a likelihood of selling pressure.  I think the Company will likely confront a negative same-store sales headline in 2017.  More relevant is that assuming the assertion that same-store sales will go negative coupled with the assertion that commodity costs will not likely be an ongoing tailwind and that both of these issues will be compounded by labor cost pressures, CAKE will incur sales deleverage and a miss to earnings expectations during 2017.  For a stock that currently trades at over 18x this year’s estimated EPS for just 8% in EPS anticipated next year, the stock is not adequately discounting these noted issues.

    The argument that food costs will likely rise in the future is not a near-term assertion.  In fact, since the Company has contracted 75% of its commodity basket, including 65% of the dairy basket, for the remainder of the year, bulls can feel confident that food costs will not be a headwind anytime this year.  Cream cheese and dairy comprise ~15% of CAKE’s commodity basket.  For 2016, cost of sales is anticipated to decline 70-80 basis points, an impressive improvement given the 80 basis point improvement in 2015.  With cost of sales approaching an all-time low for CAKE, I think the bulls are extrapolating such a trend that is unlikely to be sustainable nor favorable over time and this is not being adequately discounted as a risk in CAKE’s stock price. 

    I am not trying to specifically forecast food costs but do believe in pattern recognition and since 1960, there has only been one other time that food costs declined (1990-1992) for two consecutive years.  There were no consecutive three year periods and although it is possible that 2017 marks the first three year period in over fifty-five years, we know that part of the reason that food costs will ultimately rise is that producers (note that farm net income is down by more than 50% in the past three years) adjust accordingly for their own business.  The UDSA’s Economic Research Service is forecasting that FAH prices will increase by 1-2% next year. 

    There’s of course deflationary pressures around the world and that’s why Central Banks have been orchestrating an unprecedented magnitude of monetary stimulus and perhaps those deflationary challenges (a tailwind for restaurant food costs) will persist across food costs as well but what hasn’t changed is the fact that grocers adjusted their prices lower when food costs declined and when FAFH less FAH grows too high, restaurant traffic declines accordingly.  CAKE and its peers are wrestling with this challenge and have benefitted from lower food costs these past couple of years.  It might not be 2017 when those costs increase again but eventually those costs will increase (otherwise, there are other economic issues to incorporate into the short thesis) and the magnitude of pricing power to compensate for increasing food costs is likely to be mitigated by the acceleration of menu pricing that has recently been taken.

    As the casual dining industry confronts sluggish same-store sales driven by a negative traffic trend, the restaurant industry also confronts workforce shortages and wage pressures.  An industry expert reported the “increasing difficulty in recruiting and hiring qualified employees and managers, and increasing wages.”  Escalating labor costs, reflecting both a tight labor market and government-mandated minimum wage increases in the Northeast, West Coast, and some major cities, are offsetting some of the benefit of low commodity costs.    

    During Q2, labor was 33.2% of revenue, an increase of ~140 basis points from the prior year’s quarter (20 basis points more than the surprising magnitude of the decline in cost of sales for the quarter).  A majority of the increase was attributable to higher hourly wages.  Although wage rate inflation (at 5%) was in line with management’s expectations, CAKE did incur incremental impact from overtime.  Overall for 2016, management currently expects labor to be up 70-80 basis points, more than the 50 basis points that they initially anticipated.  Although the challenges of labor costs have become increasingly well-documented, I don’t think those issues, which are likely to escalate, are adequately discounted by CAKE’s investors.

    From 2000-2015, the average restaurant wage increase was 3%, this is also equivalent to the average change in food costs over that period.  However, the average menu price change was less, at 2.8%.  It is this reversion to the mean that I envision will begin to materialize in the next 12-18 months.  When speaking with restaurant industry experts, they all communicate that it is “impossible” for the menu price change as well as potential menu mix benefits to “consistently” compensate for both increased wages and increased food costs.  A few of those with whom I conducted primary research are most anxious of years like 2007, 2008, and 2011 when food costs increased by 7.6%, 7.7%, and 8.0%, respectively, while restaurant wages increased by 6.3%, 3.8%, and 2.1%, respectively.  During those years, restaurant menu price changes ranged from 330 to 570 basis points below the food cost increase.  Since CAKE tries to mitigate food cost volatility through contracts, the Company’s margins didn’t suffer as much until the following years when the preceding year inflationary challenges materialized in their expense base.  During those following years, CAKE’s average operating margin was just 5.1% versus 7.7% for all other years from 2007-2015.

    As one of the most labor-intensive companies within one of the most labor-intensive industries, CAKE’s exposure to wage inflation is a significant ongoing challenge that has mostly been buffered by menu pricing that I deem to be an unsustainable benefit.  In contrast to many casual dining chains, almost all of CAKE’s menu items, except those desserts manufactured at the Company’s bakery production facilities, are prepared daily at each unit.  This is among the Company’s notable competitive strengths.  However, the Company’s competitive positioning also makes CAKE a more labor-intensive business model.  Regardless of who lives in the White House this coming January, both the political momentum and populist movement will drive further minimum wage increases.  The employment environment has tightened which makes recruiting and retaining employees increasingly more difficult without the enticement of better compensation and CAKE is not only competing for talent with its peer group but also large national employers who have increased their minimum hourly wages materially above the Federal minimum wage of $7.25 to $9-10 per hour.  Furthermore, labor cost issues are particularly difficult in the state of California where CAKE has more than 15% of its units.  Some might argue that CAKE could drive towards improved labor productivity with a smaller staff and also through technology.  Management is strongly capable and has been implementing technology-driven productivity improvements including a mobile payment app, CakePay, which will be featured soon in a MasterCard commercial (free publicity benefit for CAKE) for its digital wallet solution MasterPass.  However, the notion of staff reductions (from ~170 per unit hourly staff) is not consistent with the high-touch guest experience that would be marginalized as it supposedly is core towards differentiating CAKE in the casual dining segment.

    Labor costs will be an ongoing challenge for CAKE.  In addition to over 30% of states having already increased or scheduled an increase to the minimum wage in 2016, of which ten states have scheduled further increases in 2017 (including CA and NY where ~25% units are located) and six have further increases in 2018 (again including CA and NY), there are numerous large national employers (e.g., Costco, Target, Wal-Mart, TJX, GAP) who have voluntarily increased their wages, thereby heightening the competition for CAKE when recruiting and retaining employees. 

    In California and New York, the minimum wage is expected to increase to $15 in the next few years.  Starting next year, the minimum wages in Connecticut and Massachusetts will rise to $10.10-11.00 per hour.  The average wage change of 3% since 2000 will be increasing and especially so in the current tighter employment scenario.  Furthermore, there is some risk to CAKE associated with the potential that tipping is eliminated.  Although this is unlikely a Federal mandate, we are witnessing some restaurant groups (most notably Danny Meyer’s Union Square Hospitality Group) eliminate tipping.  If this trend gains sufficient traction, it could marginalize the labor model of the casual dining segment.  CAKE and its peers benefit from customers paying a tip to their server.  The federal minimum wage for tipped employees is $2.13 per hour, but if an employee’s tips plus wage does not exceed $7.25 per hour, the restaurant owner will be fined.  In an environment of no tipping, the restaurant owner will incur more labor costs.  It is likely that restaurants would increase their menu pricing to compensate for this additional labor burden but having noted that pricing is among the reasons that restaurant traffic is struggling, this issue for CAKE would further escalate in an environment of no tipping. 

    In addition to the labor cost issues ascribed to wages, CAKE will continue to confront healthcare cost challenges.  Since CAKE is self-insured, those issues can surface as much of a surprise as evidenced from results in Q4 of 2014.  Results that quarter missed consensus margin estimates by 140 basis points largely because of higher-than-expected medical claims.    During 2014, CAKE incurred a nearly 50% increase in high-cost claims (above $50,000), with the dollar amount of each high-cost claim more than 80% higher.  Within five days after the Company’s Q4 earnings announcement, the stock had declined by more than 10%.   

     The components of potential business growth are same store sales, margin, and unit growth.  For the reasons described, I think the growth potential for same store sales and margin are challenged.  In regards to unit growth, management targets new restaurant development that meets its return criteria to achieve a Company-level return of ~15%.  Average ROIC for the Company during 2013-2015 was 14-15%.  For new units, management targets an average return of ~20%.  During fiscal years 2013-2015, average fully capitalized cash return was 23-24% for The Cheesecake Factory restaurants in the Company’s comparable sales base.  As the Company focuses its expansion on smaller markets, I anticipate that the returns from new units are likely to be less attractive than historically and at $0.02-.03 of potential EPS per unit if successful, new unit growth, at the current valuation, will not adequately compensate for the likelihood of ongoing stagnation and potential decline of the existing base in the near-term. 

    The consensus estimate, at $2.97, for EPS growth in 2017 is just 8%.  CAKE is currently trading at 18.6x this year’s EPS estimate and 17.2x next year’s estimate.  Relative to the peer group, CAKE’s 2017E P/E is ~5% premium to the peer median and ~5% discount to the peer average.  However, when CAKE’s valuation is compared to its peer group on the basis of EPS growth expected for next year, it is the second highest and almost a 60% premium to the peer median and ~55% premium to the peer average.  Although the challenges confronting the restaurant industry and specifically to the casual segment have recently become more well-documented (i.e., certainly a risk consideration), I anticipate those challenges will persist in the near-term and industry multiples are likely to compress with the likelihood of more misses and reduced guidance. 

    I don’t envision the premium multiple accorded to CAKE’s lower growth expected next year as being sustainable and I think it’s unlikely that the peer group industry multiple expands.  To the extent that CAKE were accorded the same peer group multiple for next year’s growth on CAKE’s consensus estimate, CAKE would be trading at $33.  On a DCF basis assuming FCF were to ambitiously grow by 4% in each of the next ten years and applying a 10% discount rate, CAKE would trade at ~$36.     

    Investors have not yet discounted the numerous challenges confronting CAKE.  The risks confronting CAKE include ongoing guest traffic struggles and a reversal from pricing benefits accorded to the six-year peak of FAFH less FAH.  The combination of these issues will likely lead to negative same-store sales and the inherent negative operating leverage that comes with it and especially as labor pressures escalate further. 

    Since the public market restaurant industry investor is often focused on same-store sales and CAKE has generated twenty-six quarters of consecutive growth, I anticipate that when that metric goes negative, the market is likely to adjust CAKE’s valuation accordingly.  Even if I am wrong regarding this materializing next year at CAKE, industry-related challenges should pressure the peer group’s multiple and the premium (55-60%) accorded to CAKE’s EPS growth for next year, at less than half the peer average.  I think the recent evidence of restaurant industry issues is just the beginning of ongoing headwinds and that CAKE’s consistency of same-store sales growth will be halted in the near-term, thereby reinforcing structural challenges.  The market will therefore no longer accord CAKE a premium multiple for less expected growth and the stock will decline accordingly.  I envision CAKE generating a 20% return on the short side but am mindful of the risk considerations (some noted below) and have not sized this fully yet but deem the short an attractive risk-reward at the current price.

    Risk Considerations

    Among the risks of being short CAKE includes the following:

    Management is strongly capable.  In the restaurant industry, one cannot discount the importance of execution and CAKE’s management is well-regarded for their methodical and detailed approach.  In 2015, The Cheesecake Factory was named for the second year in a row to Fortune magazine’s “100 Best Companies to Work For” list.

    This year CAKE will benefit (by .05-.08) from an additional week of operations and that additional week is “a very good additional week”, said CAKE’s CFO Douglas Benn. Last year, the fourth quarter ended on December 29th which meant it excluded the strong New Year’s holiday.  This year, CAKE’s fourth quarter will end on January 3, 2017 and therefore the Company’s sales will have benefitted from two New Year’s eves in the same year.  That said, this will become another headwind for earnings potential growth during fiscal year 2017.

    Expectations for restaurants in general and CAKE specifically have recently been lowered by downgrades at both Jefferies and Stifel.  The lower expectations of course might marginalize a short thesis if it becomes too well-documented.  Since I don’t receive research from either Jefferies or Stifel, I cannot opine on the all of the specific differences that I describe and those from the recent downgrades.  However, given the attention that those industry-wide downgrades received, there is some context reported by the general business news media.  Stifel’s downgrade is prompted by slowing restaurant sales being the “canary that lays the recessionary egg” and their belief that a recession will hit the U.S. in coming months.  Paul Westra wrote, “we confidently believe” that a recent Stifel survey showing restaurant sales decelerating “simultaneously” across all categories “is a harbinger to a U.S. recession in 2017” and “a prospective 2017 U.S. recession could be the worst ever for restaurants”.  On the same day, Andy Barish at Jefferies also downgraded multiple restaurant chains saying he was “calling the top of the restaurant cycle” after an “extensive” study suggested that the “industry has at least 18 months of challenges ahead” in terms of softer same-store sales and higher labor costs.  I have been working on the short thesis for several weeks and I would have preferred the absence of these downgrades because it inherently lowered market expectations.  My thesis is not predicated on a recession in the U.S. as Westra asserts but the overabundance of supply in the restaurant industry compounded by structural mall-based location challenges which has and is likely to continue creating traffic headwinds, and that the benefit accrued from a six-year peak in pricing relative to food costs is unsustainable. 

    Given the Company’s challenge to drive additional growth through another concept (i.e., Grand Lux and Rock Sugar) and the inherent structural casual dining segment challenges, management is likely interested in developing or acquiring a fast-casual concept.  I recognize this as a risk consideration in the near-term and I suspect the market would applaud such a strategic move by management to supplement growth through acquisition and within this market presumably ignore much of the premium paid.  Furthermore, the restaurant industry woes, which has driven valuations of some publicly-traded concepts to significantly lower multiples versus CAKE, could provide attractive acquisitions that are immediately accretive.  In managing against this and other risks, I would adjust exposure to such news and price action accordingly with an eagerness to short more CAKE at higher levels.  Also, I would view such a strategic move as reinforcement of the short thesis in regards to CAKE’s structural issues in its core business. 

    CAKE has spent substantially all its FCF on buybacks in the last three years and the Company maintains a sizeable buyback authorization to buffer a fundamental-driven decline.  The Company’s buyback has accounted for about one-third of EPS growth.

    CAKE maintains a strong balance sheet and could expand its buyback activity to further support the stock although management has communicated an unwillingness to pursue leverage for such purposes.

    CAKE’s international business remains small and offers a higher return per unit based on the royalty-driven arrangement.  Each international unit could contribute ~$0.01 to EPS.    

    The Company recently raised its dividend, now $.96 on an annualized basis, and in this distorted/suppressed interest rate environment, the dividend could provide some downside support.  That said, there are publicly-traded restaurants with a much higher implied yield (e.g., DIN at almost 5%), so I don’t think the dividend is high enough to prevent the stock from ultimately declining to my target price.

    An overarching risk consideration in this environment is the notion of shorting in general when price discovery is distorted by Central Bank activities.

    I do not hold a position with the issuer such as employment, directorship, or consultancy.
    I and/or others I advise do not hold a material investment in the issuer's securities.

    Catalyst

    Selected Catalysts

    ·         Negative traffic trends continue

    ·         Consistency of same-store sales is eclipsed

    ·         Margin erodes as caused by any combination of moderation of pricing, food cost inflation, and labor cost pressures escalating

    ·         Success and productivity of new units becomes questionable, thereby marginalizing CAKE’s ability to drive towards 300 unit goal

    ·         Valuation is re-rated to adjust for lower growth prospects

    ·         CAKE pays a substantial premium to acquire another concept to drive potential growth; market might react positively (i.e., inclined to short more) despite premium paid but such acquisition would reinforce confidence that core business is likely to struggle in near/medium-term (e.g., would remind me of Ruby Tuesday’s unsuccessful drive to diversify with Lime acquisition while ongoing struggles confronted their core brand)

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