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? See what our analysts have to say in our full research report, it’s free.
We’re happy investors have made money, but we're swiping left on The Cheesecake Factory for now. Here are three reasons why CAKE doesn't excite us and a stock we'd rather own.
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.
1. Weak Operating Margin Could Cause Trouble
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.
2. 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 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.
3. 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 6× net-debt-to-EBITDA ratio (based on its EBITDA of $295.8 million over the last 12 months) shows the company is overleveraged.
At this level of debt, incremental borrowing becomes increasingly expensive and credit agencies could downgrade the company’s rating if profitability falls. The Cheesecake Factory could also be backed into a corner if the market turns unexpectedly – a situation we seek to avoid as investors in high-quality companies.
We hope The Cheesecake Factory can improve its balance sheet and remain cautious until it increases its profitability or pays down its debt.
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 13× 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. Let us point you toward a fast-growing restaurant franchise with an A+ ranch dressing sauce.
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