Don’t Slice Your Profits: Why CAKE Falls Flat, Buy This Instead
The Cheesecake Factory: A Cautionary Tale of Weak Operating Margin, Previous Growth Initiatives That Haven’t Paid Off, and High Debt Levels
Over the past six months, The Cheesecake Factory has been a great trade, beating the S&P 500 by 28.4%. Its stock price has climbed to $48.75, representing a healthy 33.6% increase. This was partly thanks to its solid quarterly results, and the performance may have investors wondering how to approach the situation.
Is there a buying opportunity in The Cheesecake Factory, or does it present a risk to your portfolio?
Why Is The Cheesecake Factory Not Exciting?
Celebrated for its delicious (and free) brown bread, gigantic portions, and delectable desserts, Cheesecake Factory (NASDAQ:CAKE) is an iconic American restaurant chain that also owns and operates a portfolio of separate restaurant brands.
Operating Margin – A Key Measure of Profitability
Operating margin is an important measure of profitability for restaurants as it accounts for all expenses keeping the business in motion, including food costs, wages, rent, advertising, and other administrative costs. The Cheesecake Factory was profitable over the last two years but held back by its large cost base. Its average operating margin of 4.1% was weak for a restaurant business. This result is surprising given its high gross margin as a starting point.
Gross Margin
Gross margin is the difference between revenue and the direct costs associated with generating that revenue. A higher gross margin means more money left over after accounting for variable expenses like food, labor, and supplies. The Cheesecake Factory’s gross margin was 25.4% in its last reported quarter, which is above average for the restaurant industry.
However, when operating margins are considered, a different picture emerges. Operating margin accounts for all fixed costs such as rent, salaries, marketing expenses, and other operational costs that remain even if revenue falls to zero. This measure indicates how much profit remains after deducting all fixed and variable expenses from sales.
The Cheesecake Factory’s average operating margin of 4.1% over the last two years is relatively low compared to its peers in the restaurant sector. Its weak operating margin could be a cause for concern, as it may indicate difficulties in managing costs or inefficiencies in operations.
Previous Growth Initiatives Haven’t Paid Off Yet
Growth gives us insight into a company’s long-term potential, but how capital-efficient was that growth? A company’s ROIC (Return on Invested Capital) explains this by showing how much operating profit it makes compared to the money it has raised (debt and equity).
The Cheesecake Factory’s five-year average ROIC was negative 0.3%, meaning management lost money while trying to expand the business. Its returns were among the worst in the restaurant sector.
Return on Invested Capital
Return on invested capital is a financial metric used to evaluate how effectively a company uses its capital. It measures the return generated by shareholders for every dollar of equity invested in the business, taking into account both debt and equity components. A higher ROIC indicates that management is generating more operating income relative to its investments.
The Cheesecake Factory’s negative 0.3% five-year average ROIC suggests poor management decisions or inefficient use of capital during this period. As investors, we are wary of companies with low returns on invested capital as they may struggle to generate sufficient cash to meet their obligations and grow the business sustainably.
High Debt Levels Increase Risk
As long-term investors, the risk we care about most is the permanent loss of capital, which can happen when a company goes bankrupt or raises money from a disadvantaged position. This is separate from short-term stock price volatility, something we are much less bothered by.
The Cheesecake Factory’s $1.89 billion of debt exceeds the $84.18 million of cash on its balance sheet. Furthermore, its 6Ă— net-debt-to-EBITDA ratio (based on its EBITDA of $295.8 million over the last 12 months) shows the company is overleveraged.
Net Debt Position
Net debt refers to a company’s total debt minus any cash or liquid assets available to meet short-term obligations. A high net-debt-to-EBITDA ratio indicates significant leverage, which can increase financial risk and make it difficult for companies to service their debts during periods of reduced profitability or economic downturns.
The Cheesecake Factory’s high debt levels not only pose a direct risk but also limit its flexibility in the face of unexpected market movements. Incremental borrowing becomes increasingly expensive at this level of debt, which can further exacerbate financial difficulties if economic conditions worsen.
Final Judgment
The Cheesecake Factory isn’t a terrible business, but it isn’t one of our picks. With its shares topping the market in recent months, the stock trades at 13Ă— forward price-to-earnings (or $48.75 per share). This valuation is reasonable, but the company’s shakier fundamentals present too much downside risk.
We’re pretty confident there are more exciting stocks to buy at the moment.
