Description

Cheesecake Factory is a perennial valuation short that appears to facing a fundamental inflection point that the stock is clearly not reflecting.
Before providing my rationale for shorting CAKE at this time and level, I will offer a little back ground in how we got here today. The first restaurant opened in 1978 and grew slowly until its 1992 IPO. Following the IPO and two subsequent secondary offerings, the company has grown at a rapid rate to its current total of 69. While 69 restaurants pails in comparison to larger chains such as Applebee’s and Red Lobster, the Cheesecake Factory is not of your cookie cutter variety. The stores have industry leading sales/sq. ft. at $1,000 and top tier unit economics leading to a ROIC in excess of 30%.
Shorts have been attracted to this company for many years mainly due to a high relative valuation and a history of restaurant company blowups
Having explained part of the success of the company, I will not try to provide my reasons for a shorting the shares here. The base of the call does center on valuation. At $37.83, the shares are trading just over 30x NTM earnings of $1.25 and 14x EBITDA. As opposed to some of the other high multiple restaurant companies like PNRA and PFCB, earnings estimates have been coming down slightly for CAKE as margins have been a bit weaker than expected and comps have fallen behind historical levels. If my thesis is correct, CAKE should no longer be valued on historical multiples as it is transitioning to a more mature, slower growth restaurant company that typically receive closer to a 15x NTM P/E multiple. While the lofty valuation is obvious, the difficult part is figuring out what will be the catalyst to bring the stock back down. The company’s growth has been slowing the last several years on both the top and bottom line. Having posted earnings growth in excess of 40% in the late 90’s, EPS growth came in just above 15% this past quarter and could be below this level if they miss 3Q by just a penny. Seeing that trends have slowed to this degree and will become more challenging going forward, it doesn’t seem appropriate that the stock trades above its average NTM P/E multiple of 28x. The main culprit for the decline in growth rate is simply a by product of their uniqueness. The problem is that it is this very uniqueness that has and should soon get the company into trouble. It is extremely difficult to open these $10 million plus volume stores from both an operational and real estate perspective. There are only so many great, high traffic locations that become available in a given year. With their scheduled openings of 14 this year, they are stretching the limit of premium sites. As they begin to compromise and resort to slightly lower tier real estate, they will no longer be able to maintain their sales/sq. ft. and ROIC. They have barely been hanging on in regards to these metrics and may be reaching the tipping point. Once investors see ROIC come down, the future value of restaurants implicit in the stock price will begin to come out.
The only problem with the company isn’t just real estate and potential future growth. The fundamentals of their current restaurants have also slowed down. SSS turned to negative 2% in the 1st Q and just got into positive range at .3% for 2Q. These trends are well below their competition and their explanations regarding weather don’t seem to tell the whole story. The company line is that they only plan and can achieve 1-2% SSS (primarily from price) because they are constrained by their leading sales/sq ft. The problem also has to do with the honeymoon effect of new stores. The excitement around new openings leads to higher than sustainable volumes for the 1st year or so. While I cannot deny the point about sales/sq. ft. and recognize that it is a high class problem, it will still present problems for the company in managing margins. Assuming an efficiently run restaurant, the only real way to raise margins is through same store sales. Given capacity constraints, this is not as achievable of a goal as it is for competitors. This should not have an affect on future openings, but it should be detrimental to current restaurants in an unforgiving cost environment like we are currently in. Labor has been difficult, insurance has become a major problem, utility costs are way up, and beef and chicken costs have recently spiked.
When restaurant companies see fewer opportunities for square footage growth with their core concept, they often try to develop or acquire another growth vehicle. The company, and evidently investors, believes that their Grand Lux Café could be that vehicle. The differences between the two concepts are fairly slight and have mainly to do higher price points and more expansive menu. Grand Lux Café was developed due to strong demand and lease restrictions from opening additional Cheesecakes. The 1st store was in Las Vegas and the next two were in Chicago and LA. Due to their similarities and even higher necessary volumes, the potential for this concept looks severely limited. They plan for two more openings in 2004 in Dallas and Boca Raton. Assuming the company goes ahead with the Dallas location at the rumored located, I am pretty confident that they will not achieve the same success as with prior units. This location simply does not generate the same constant, traffic levels that the others enjoy.
CAKE being a favorite of momentum investors coupled with the higher than average short interest has led to substantial price increases for the stock in short periods of time. Having just gone through one of these periods that has brought the stock back to 52 week highs, I believe that there is a catalyst right around the corner that could rein the company in and send the momentum money out of the stock. The current year has the company committed to opening 14 stores or over 1 a month. They only opened 4 in the 1st half of the year with analyst estimates for 5 each remaining quarter. Considering that only 2 stores has been opened quarter to date, CAKE needs to open a store each remaining week to hit their plan for the Q. While this should create many logistical and operational problems, the real problem is that the company will be forced to take the entire pre-opening expense up front with only a small benefit of incremental revenues and earnings for the new restaurants. CAKE just hit their number in Q2 by delaying this pre-opening expense and pushing it out into the 2H. Thus the negative effect with be even worse this quarter which most likely was also without the benefit of a better SSS. A preannouncement ahead of one of their upcoming conference presentations (at BoA on 9/16 and RBC on 10/2) or a miss when they report on October 21st could be the necessary catalyst.


Risks to Short
- Same store sale improvement back to 2%+ range could cure any near term margin contraction problems and provide many with the conviction that fundamentals have bottomed.
- If management speaks more optimistically about their second concept, Grand Lux, concerns regarding longer term square footage growth could be eliminated
- As with other high multiple restaurant stocks, CAKE carries a rather large short interest currently at 15% of the float and a11 day coverage ratio.

Fiscal Year 09/2002 01/2003 12/2002 12/2002 12/2002
Symbol SBUX KKD PNRA CAKE PFCB
Stock Price $28.88 $40.95 $45.64 $37.83 $47.74
52 week High $29.49 $49.74 $47.40 $38.34 $51.22
52 week Low $19.60 $26.42 $23.64 $24.90 $26.28
% off high -2.1% -17.7% -3.7% -1.3% -6.8%
% off low 47.3% 55.0% 93.1% 51.9% 81.7%

14.28 28.13 15.43 22.60 16.46
Shares Outstanding 400.2 60.5 29.6 51.1 26.0
Market Capitalization 11,557.4 2,476.6 1,350.9 1,934.3 1,242.0
Enterprise Value 10,997.34 2,516.12 1,318.26 1,907.26 1,191.40
Float 381.40 53.80 22.80 40.10 22.30
Short Interest 14.17 11.32 6.23 6.31 3.42
Short/Float 3.72% 21.03% 27.34% 15.73% 15.33%
Avg. Daily volume (in 000s) 3927.0 836.7 712.2 748.9 574.8
Avg. Daily volume $$ (in 000s) $113,413 $34,263 $32,507 $28,331 $27,442
Days to Cover 3.61 13.52 8.75 8.42 5.95
Avg. Daily volume (in 000s) L10days 3073.0 1160.0 480.0 486.0 311.0
Avg. Daily volume $$ (in 000s) $88,748 $47,502 $21,907 $18,385 $14,847
Days to Cover 4.61 9.76 12.99 12.98 10.99

Dividend 0.00 0.00 0.00 0.00 0.00
Yield 0.0% 0.0% 0.0% 0.0% 0.0%

Book Value/Share $4.94 $5.53 $5.90 $8.10 $7.52
Book Value 1976.82 334.58 174.56 414.28 195.73
Price/Book 5.85 7.40 7.74 4.67 6.35
3 YR Avg. 5.70 5.38 4.52
Premium/Discount to Avg. 2.6% 43.7% 40.4%

I. P/E VALUATION
Earnings Per Share (CY)
1998 $0.29 $(0.01) $0.46 $0.27
1999 0.29 -0.01 0.46 0.27
2000 0.38 0.26 0.26 0.64 0.43
2001 0.48 0.44 0.46 0.79 0.62
2002 0.57 0.64 0.73 0.96 0.81
2003E 0.71 0.88 1.01 1.13 1.07
2004E 0.86 1.15 1.32 1.39 1.34
next 12 mos 0.78 1.03 1.14 1.25 1.19


Price/Earnings 1999 99.59 (4,564.00) 82.63 176.81
2000 76.50 154.65 175.54 59.11 111.02
2001 60.17 94.05 100.31 47.89 77.63
2002 50.37 63.74 62.52 39.41 58.94
2003E 40.43 46.40 45.25 33.36 44.49
2004E 33.44 35.68 34.67 27.16 35.65
next 12 mos 36.89 39.59 39.87 30.21 40.22

On '04 Target Multiple 40.00 30.00 30.00
Target Price 52.66 41.78 40.18
Upside 15.4% 10.4% -15.8%

TEV/EBITDA 1999 41.79 160.50 108.16 42.25 86.40
2000 37.82 81.57 65.58 29.78 50.50
2001 24.31 49.49 40.77 24.18 33.68
2002 20.26 34.89 26.77 19.16 22.47
2003E 17.38 26.34 19.81 15.23 17.51
2004E 15.10 20.73 15.53 12.65 14.11

On '04 Target Multiple 10.00
Target EV $1,508
Upside -20.95%

Expand TEV/EBITDAR

Free Cash Flow Analysis
2002 Net Income 229.4 38.9 21.6 49.1 21.1
D&A 177.1 8.0 14.0 22.9 14.4
Cap Ex -365.54 -56.73 -27.12 -88.04 -49.47
Free Cash Flow before Dividends 40.99 (9.92) 8.46 (16.09) (14.02)
Dividends 0.00 0.00 0.00 0.00 0.00
Free Cash Flow after Dividends 40.99 (9.92) 8.46 (16.09) (14.02)

FCF/share 0.10 -0.16 0.29 -0.31 -0.54
Price/FCF 281.95 -249.73 159.70 -120.21 -88.56
FCF Yield 0.4% -0.4% 0.6% -0.8% -1.1%

2003 Net Income 285.86 53.38 29.85 57.98 27.92
D&A 177.1 8.0 14.0 22.9 14.4
Cap Ex -410.00 -56.73 -27.12 -90.00 -49.47
Free Cash Flow before Dividends 52.94 4.60 16.70 (9.16) (7.18)
Dividends 0.00 0.00 0.00 0.00 0.00
Free Cash Flow after Dividends 52.94 4.60 16.70 -9.16 -7.18

FCF/share 0.13 0.08 0.56 -0.18 -0.28
Price/FCF 218.30 537.82 80.87 -211.26 -172.98
FCF Yield 0.5% 0.2% 1.2% -0.5% -0.6%

2004 Net Income 345.66 71.21
D&A 194.8 25.1
Cap Ex (475.00) (45.0)
Free Cash Flow before Dividends 65.46 51.36
Dividends 0.00 0.00
Free Cash Flow after Dividends 65.46 51.36

FCF/share 0.16 1.00
Price/FCF 2.55 0.05
FCF Yield 0.6% 2.7%

Earnings Growth
1999 to 2000 30.17% -2700.00% 39.80% 59.26%
2000 to 2001 27.15% 64.44% 75.00% 23.44% 43.02%
2001 to 2002 19.44% 47.56% 60.44% 21.52% 31.71%
2002 to 2003 24.59% 37.37% 38.16% 18.13% 32.48%
2003 to 2004 20.92% 30.04% 30.52% 22.81% 24.80%
2001-2004 average 21.63% 38.14% 42.49% 20.80% 29.62%
2003 PE/Growth Rate 1.87 1.22 1.06 1.60 1.50
FC LT growth rate 19.85% 32.50% 31.63% 21.75% 26.86%
2003 PE/FC LT Growth Rate 2.04 1.43 1.43 1.53 1.66

Quarterly Earnings: Calendar year

2001a 1Q 0.08 0.10 0.11 0.17 0.16
2001a 2Q 0.12 0.10 0.08 0.21 0.14
2001a 3Q 0.14 0.11 0.10 0.20 0.14
2001a 4Q 0.15 0.14 0.16 0.22 0.19

2002a 1Q 0.11 0.15 0.18 0.21 0.20
2002a 2Q 0.14 0.15 0.13 0.26 0.19
2002a 3Q 0.15 0.17 0.17 0.24 0.17
2002E 4Q 0.20 0.19 0.25 0.26 0.25

2003E 1Q 0.13 0.21 0.25 0.25 0.26
2003E 2Q 0.17 0.21 0.19 0.30 0.27
2003E 3Q 0.17 0.22 0.23 0.28 0.25
2003E 4Q 0.23 0.26 0.33 0.31 0.29

Quarterly Earnings Growth

2000 - 2001 1Q 33.33% 48.15% 75.00% 41.67% 47.62%
2000 - 2001 2Q 33.33% 60.00% 45.45% 31.25% 42.11%
2000 - 2001 3Q 27.27% 62.96% 66.67% 17.65% 47.37%
2000 - 2001 4Q 25.00% 86.67% 68.42% 22.22% 37.04%

2001 - 2002 1Q 37.50% 50.00% 71.43% 23.53% 29.03%
2001 - 2002 2Q 16.67% 50.00% 62.50% 23.81% 40.74%
2001 - 2002 3Q 7.14% 54.55% 70.00% 20.00% 21.43%
2001 - 2002 4Q 33.33% 35.71% 56.25% 18.18% 35.14%

2002 - 2003 1Q 18.18% 40.00% 38.89% 19.05% 30.00%
2002 - 2003 2Q 21.43% 40.00% 46.15% 15.38% 42.11%
2002 - 2003 3Q 15.29% 31.93% 36.97% 16.39% 47.96%
2002 - 2003 4Q 16.67% 36.84% 33.71% 19.74% 16.62%

Change in Current Qtr Estimate (%)
One Week 0.00% 0.00% 0.00% 0.00% 0.04%
One Month 0.34% 1.37% 0.00% -0.24% 0.00%
Three Months -1.01% 1.95% 0.62% -2.69% 1.19%

Change in FY 2002 Estimate (%)
One Week 0.00% 0.00% 0.00% -0.12% 0.09%
One Month 0.03% 1.44% 0.07% -0.15% 0.07%
Three Months 0.80% 1.95% 0.93% -1.89% 1.30%

Change in FY 2003 Estimate (%)
One Week 0.00% -0.24% 0.00% 0.00% 0.05%
One Month 0.23% 0.10% 0.33% -0.06% 0.06%
Three Months 3.36% 1.54% 0.97% -1.32% 1.04%

Quarterly Revenues

2001a 1Q 629 88 43 121 72
2001a 2Q 663 90 53 132 76
2001a 3Q 690 100 53 138 81
2001a 4Q 805 117 56 149 89

2002a 1Q 783 111 56 150 98
2002a 2Q 835 115 77 165 102
2002a 3Q 865 129 65 162 107
2002E 4Q 1,004 137 73 174 116


Quarterly Revenue Growth: Year over Year
1998 - 1999 1Q 27.29% 18.32% -15.52% 25.75% 93.75%
1998 - 1999 2Q 26.72% 19.60% 3.95% 33.44% 91.50%
1998 - 1999 3Q 32.76% 25.83% 34.00% 33.94% 102.39%
1998 - 1999 4Q 30.49% 23.11% 28.99% 30.41% 96.75%
1999 - 2000 1Q 34.82% 32.89% 28.99% 28.45% 68.72%
1999 - 2000 2Q 31.55% 36.42% 0.00% 22.68% 62.33%
1999 - 2000 3Q 23.00% 37.02% -53.68% 21.19% 49.36%
1999 - 2000 4Q 26.08% 39.48% -45.36% 32.19% 40.71%
2000 - 2001 1Q 24.20% 24.06% -45.36% 25.40% 40.86%
2000 - 2001 2Q 18.88% 27.81% -31.63% 25.68% 42.92%
2000 - 2001 3Q 18.05% 28.12% 47.60% 23.62% 31.67%
2000 - 2001 4Q 20.67% 42.98% 30.77% 18.40% 29.83%
2001 - 2002 1Q 24.46% 26.32% 30.77% 24.65% 34.63%
2001 - 2002 2Q 26.01% 28.01% 44.54% 25.05% 32.95%
2001 - 2002 3Q 25.48% 29.38% 22.89% 17.70% 32.89%
2001 - 2002 4Q 24.61% 16.78% 31.12% 17.24% 29.71%

II. ENTERPRISE VALUATION
Current Current Current Current Current
Cash/ST Investments 565.31 25.48 32.69 27.07 52.05
ST Debt 0.72 4.71 0.00 0.00 1.38
LT Debt 4.54 60.33 0.00 0.00 0.10
Preferred/Other 0.00 0.00 0.00 0.00 0.00
Net Debt (560.0) 39.6 (32.7) (27.1) (50.6)
Market Cap 11,557.4 2,476.6 1,350.9 1,934.3 1,242.0
Total Ent. Value 10,997.3 2,516.1 1,318.3 1,907.3 1,191.4
Expand Capitalized Leases

S&P Bond Rating

EBITDA(MM) 1999 263.19 15.68 12.19 45.14 13.79
2000 290.80 30.85 20.10 64.04 23.59
2001 452.42 50.84 32.34 78.88 35.37
2002 542.91 72.12 49.25 99.56 53.02
2003E 632.86 95.54 66.54 125.27 68.06
2004E 728.21 121.40 84.89 150.77 84.42
Expand EBITDAR

EBITDA multiple sensitivity to 1 pt. Multiple change $1.58 $1.58 $2.25 $2.45 $2.62
as % of stock price 5.5% 3.9% 4.9% 6.5% 5.5%


Full Year 2002 EBITDA
Net Income 229.44 38.86 21.61 49.09 21.07
Taxes 136.38 23.82 13.59 27.61 11.72
Tax Rate 37.3% 38.0% 38.6% 36.0% 35.7%
Interest expense (income) 0.00 0.34 0.07 0.00 0.30
D&A 177.09 7.96 13.97 22.86 14.37
Minority Interest Expense 0.00 1.15 0.01 0.00 5.55
Investment Income
EBITDA 542.9 72.1 49.2 99.6 53.0
Rent 41.6
EBITDAR 141.14

Full Year 2003 EBITDA Estimate
Net Income 285.86 53.38 29.85 57.98 27.92
Taxes 169.91 32.72 18.78 32.62 15.53
Tax Rate 37.3% 38.0% 38.6% 36.0% 35.7%
Interest expense (income) 0.00 0.34 0.07 6.15 0.34
D&A 177.09 7.96 17.83 28.52 18.72
Minority Interest Expense 0.00 1.15 0.01 0.00 5.55
Investment Income
EBITDA 632.9 95.5 66.5 125.3 68.1
Rent 49.9
EBITDAR 175.17

Full Year 2004 EBITDA Estimate
Net Income 345.66 69.41 38.97 71.21 34.84
Taxes 205.46 42.55 24.51 40.06 19.38
Tax Rate 37.3% 38.0% 38.6% 36.0% 35.7%
Interest expense (income) 0.00 0.34 0.07 4.80 0.85
D&A 177.09 7.96 21.34 34.70 23.80
Minority Interest Expense 0.00 1.15 0.01 0.00 5.55
Investment Income
EBITDA 728.2 121.4 84.9 150.8 84.4
Rent 59.9
EBITDAR 210.64

III. FINANCIAL AND OPERATING STATISTICS
Leverage:
Total Debt/Total Assets 0% 15% 0% 0% 1%
Net Debt/Total Cap (at market value) -5.1% 1.6% -2.5% -1.4% -4.2%
Net Debt/2003E EBITDA (0.88) 0.41 (0.49) (0.22) (0.74)
2003 EBITDA/interest expense 283.50 924.17 20.37 200.17
Current ratio 1.78 2.30 2.00 1.13 1.54
Profitability LTM
Gross margin 18.73% 20.36% 71.55% 69.79%
SG&A % 5.12% 5.70% 37.27% 36.54%
EBITDA margin 16.73% 16.47% 15.49% 11.01%
EBIT margin 10.78% 13.85% 11.85% 7.68%
Pretax margin 10.78% 11.76% 12.92% 11.85% 7.68%
Tax rate 38.17% 39.31% 36.50% 35.70% 34.31%
Net Margin 6.67% 7.27% 8.21% 7.62% 5.04%
ROA 10.90% 10.68% 14.00% 11.67% 11.38%
ROE 14.14% 15.56% 16.80% 14.13% 13.96%

Efficiency
Days Receivable Turnover 9.52 31.04 8.98
Inventory turns 12.36 17.13 20.39 9.22 56.84
Inventory/payables

VI. ESTIMATE DISPERSION
High 2002 0.68 0.92 1.01 1.17 1.09
Mean 2002 0.67 0.90 1.01 1.13 1.07
Low 2002 0.67 0.89 1.00 1.10 1.07
High/Mean 0.99% 1.90% 0.14% 3.17% 1.58%
Low/Mean 0.50% 1.44% 0.86% 3.09% 0.29%

High 2003 0.85 1.19 1.35 1.45 1.37
Mean 2003 0.84 1.17 1.32 1.39 1.34
Low 2003 0.81 1.14 1.30 1.32 1.30
High/Mean 1.53% 1.71% 2.55% 4.12% 2.30%
Low/Mean -3.25% -2.56% -1.25% -5.22% -2.93%

High Next Q 0.18 0.23 0.24 0.30 0.26
Mean Next Q 0.17 0.22 0.23 0.28 0.25
Low Next Q 0.17 0.22 0.23 0.26 0.25
High/Mean 4.08% 2.55% 3.07% 7.40% 3.36%
Low/Mean -1.70% -1.91% -1.23% -6.92% -0.61%

VII> RISK/REWARD ANALYSIS
Upside on 2003 EPS $0.85 $1.19 $1.35 $1.45 $1.37
Multiple 37.67 48.09 41.41 30.61 43.15
Stock Price $32.02 $57.23 $55.90 $44.39 $59.11
% Upside 10.86% 39.75% 22.49% 17.34% 23.82%
Downside 2003 EPS $0.81 $1.14 $1.30 $1.32 $1.30
Multiple 25.03 25.54 20.65 19.88 22.14
Stock Price $20.28 $29.12 $26.85 $26.25 $28.78
% Downside -29.79% -28.89% -41.17% -30.62% -39.72%
Risk Reward: Upside/Downside Ratio 0.36 1.38 0.55 0.57 0.60

CFROI FY-1 8.7 8.1 14.3 8.5 11.9
FY0 8.6 9 9.6 8.5 11.5
FY1 9.1 10 11.6 9.2 12.5
FY2 9.3 11.3 13.5 9.9 12.6

Catalyst

Catalyst:
The catalyst is a potential preannouncement ahead of their presentation at the BoA conference. If they don’t preannounce here or before the RBC conference 2 weeks later, they may still may miss consensus estimates for the 3Q and guide below for 4Q. The key culprit for the miss could be from pre-opening expenses (besides weak SSS). They barely hit their number for the 2Q due to lower than expected pre-opening expenses that were pushed out. Even after analyst incorporated this into their new estimates (and moved consensus down a penny), it should come in worse due to delayed openings. This could be the catalyst that forces momentum money out of the name and causes others to question fair valuation for the company.