Some people ask the secret of our long marriage. We take time to go to a restaurant two times a week. A little candlelight, dinner, soft music and dancing. She goes Tuesdays, I go Fridays. − Henny Youngman
We all know that The Cheesecake Factory (CAKE) is an iconic and valuable brand that will bounce back when there is clarity about virus containment. We also know that the stock has underperformed since January 2017 when it used to hover around $63. It is also common knowledge that CAKE has slashed its operating costs because of the pandemic.
Sure, we know a lot of things. What we need to figure out is whether it makes sense to invest in CAKE at its current price of about $28 (as of September 11, 2020). I have deep-dived into its financials and here is the analysis.
Volume and Costs
CAKE needs to generate very humongous volumes to remain profitable because its operating costs are extremely high.
Image Source: CAKE’s SEC Filing
In Q2 2020, the company generated $296 million in revenues and incurred operating losses because it had to spend $352 million on raw materials, labor, other operating costs, and administrative expenses. In the same period in 2019, CAKE generated $603 million in sales and ended up spending $539 million in expenses under the same heads mentioned above.
The company generated $64 million in operating profit in the pre-COVID-19 era when the situation was normal. In percentage terms, it generated an operating profit of 11% on sales. In Q2 2020, its sales dived 50% year over year, and the company made operating losses of $56 million, as per the income statement above. In percentage terms, the company’s operating loss worked up to 19% of sales.
So, to deliver healthy profits, CAKE needs to increase its turnover dramatically. Sure enough, it may be aiming for sales numbers above $1 billion per quarter, and it will probably achieve its target in the very long run. However, in the medium term, the going looks tough because no one is sure about when the virus will be contained and when CAKE’s turnover will return to its 2019 days. And even after the virus does get controlled, the economy is going to take time to get back to its pre-COVID-19 levels.
Therefore, CAKE is in for the long haul.
Cash Management
Image Source: CAKE’s SEC Filing
In Q2 2020, CAKE borrowed $90 million in debt and issued $200 million worth of preferred shares. The liquidity helped it cover-up about $36 million in operating cash leakage and invest about $30 million in property and equipment.
In May 2020, the company negotiated on its borrowing-related covenants and got its earlier covenants of maintaining (i) a Net Adjusted Leverage Ratio of 4.75 and (ii) a minimum EBITDAR (Earnings Before Interest, Taxes, Depreciation, Amortization, and Restructuring) to interest and rent expense ratio of 1.9 pushed to Q2 2021.
New liquidity covenants are now in force until Q1 2021. These would require the company to maintain liquidity of at least $65 million (p. 10) at the end of each calendar month. To fulfill the liquidity covenant and to sustain liquidity through the pandemic disruption, CAKE issued preferred convertible stock worth $200 million. The preferred stockholders have the right to convert their stock into common stock at a conversion price of $22.23 per share. This preferred stock will be treated on par with common stock and it will be entitled to participate in dividends whenever declared.
The COVID-19 Impact on Consumer Discretionary Spends
COVID-19 has poisoned the profits of restaurants by cooking up mass unemployment, throwing cold water on consumer sentiment, and sprinkling a generous dose of uncertainty on the economy. People have gone from spending to saving, and the outgoing have become homebodies. McKinsey estimates that many of the habits picked up in this depression will continue even after the virus is contained.
Image Source: McKinsey
Moreover, the folks who like to hang out and visit restaurants frequently prefer outdoor dining spaces these days. Unfortunately, only a limited part of any restaurant’s dining space is located outdoors and CAKE is no exception. Some 85% of its stores are located inside or near a mall, which people are avoiding now. It all seems uphill for the company.
Summing Up
Despite its iconic status and brand image, an investment in CAKE looks tasteless in the medium term because:
1. It needs high volumes to generate healthy profits, and no one is certain when things will return to normal. The virus has to be contained first and then the economy has to move back to its pre-COVID-19 levels. All this will not be possible in the medium term.
2. The preferred stock conversion price of $22.23 is a dampener.
3. Consumer discretionary spending is expected to take a hit until the unemployment rate falls back to its pre-virus days.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: This writing is for informational purposes only and Lead-Lag Publishing, LLC undertakes no obligation to update this article even if the opinions expressed change. It does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction. It also does not offer to provide advisory or other services in any jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Lead-Lag Publishing, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.
