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The Cheesecake Factory, Inc. (NASDAQ:CAKE)

Q1 2009 Earnings Call

April 23, 2009 5:00 pm ET

Executives

Jill Peters – Investor Relations

David Overton – Chief Executive Officer

Douglas Benn– Chief Financial Officer

Analysts

John Glass – Morgan Stanley

Joseph Buckley – Bank of America-Merrill Lynch

Jeffery Bernstein – Barclays Capital

Steven Kron – Goldman Sachs

Sharon Zackfia – William Blair

Jake Bartlett – Oppenheimer & Co

Destin Tompkins – Morgan, Keegan & Company

Brad Ludington – Keybanc Capital Markets

Bryan Elliott – Raymond James

Rob Weiler – Piper Jaffray

Colin Guheen – Cowen and Company

Christopher O'Cull – Suntrust Robinson Humphrey

Operator

Good evening, ladies and gentleman, and welcome to the first quarter Cheesecake Factory earnings conference call. (Operator Instructions). I would now like to turn the call over to Ms. Jill Peters.

Jill Peters

Good afternoon and welcome to our first quarter earnings call. I am Jill Peters, Vice President of Investor Relations. With us today are David Overton, Chairman and Chief Executive Officer, and Doug Benn, Executive Vice President and Chief Financial Officer.

Before we begin, let me quickly remind you that during this call items may be discussed that are not based on historical facts and are considered forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Actual results could differ materially from those stated or implied in forward-looking statements as a result of the factors detailed in today’s press release which is available in the Investors Section of our website at thecheesecakefactory.com and in our filings with the Securities and Exchange Commission.

All forward-looking statements made on this call speak only as of today’s date, and the company undertakes no duty to update any forward-looking statements. On the call today, David will begin by providing some opening remarks. Doug will then take you through our operating results in detail and update our expectations for 2009. Following that, we’ll open the call to questions.

Without further delay, I’ll turn the call over to David.

David Overton

Our results for the first quarter were better than we expected, primarily as a result of a significant upturn in comparable sales relative to the fourth quarter. That traffic was the main driver with an almost 3 percentage point improvement this quarter from fourth quarter levels. Another important development in the first quarter was the moderating of the degree to which guests were managing their checks. Guests are still reducing their beverage orders, both alcoholic and nonalcoholic, but dessert orders are up year over year helping to boost our average check. While we delivered solid results for the first quarter, and earnings were $0.06 above the high end of our range, we are reminded by the news media on a daily basis that the economy remains weak. Unemployment is high, real estate values are down, and while the consumer confidence index showed improvement recently, it remains low. This is all the more reason for us to stick to our strategy and continue to focus on what we can control. This is the approach that we took in the first quarter, and the approach that we will continue to take throughout the year.

Our key priorities have not changed. We are focused on guest satisfaction, product development, cost savings, and debt repayment. We executed across all of these priorities in Q1, and I’ll share some thoughts with you on the progress in each area.

First, everything we do in our restaurants, we do to deliver a great experience to our guests. We know that once they enter our restaurants, their experiences are entirely within our control, so we concentrate on executing it every step, from quoting an accurate wait time all the through the timely delivery and closeout of the check. Most of our restaurants are on a wait during lunch and dinner, and accurate quote is an important service metric. During the past 12 months, we’ve improved on this metric by 5 percentage points. This contributed to a 7 percentage point gain in overall guest satisfaction scores during the same timeframe.

Our guest satisfaction scores are a leading indicator of whether a guest will return or recommend the Cheesecake Factory, so it’s an important metric for us to track and always try to improve upon. On the product development front, the rollout of our small plates and snacks menu was completed in mid-March, and the outcome that we have seen to date has been positive. This menu is a way for us to provide a broader array of price points and promote a greater value perception while still maintaining our standards for quality and innovation.

We’ve seen guests usually order these as an add-on when they might not have otherwise ordered an appetizer and also for shared dining. Our data shows that guests who ordered from the small plates and snacks menu during the first quarter had check averages that were higher than those for guests who did not order from this menu. In addition, we are seeing the benefit to our cost of sales from these items as a result of their favorable food costs. Our second quarter marketing promotion will emphasize this new menu category, which we believe is an effective way for us to increase guest awareness and drive trial usage.

Second quarter promotion will further build on our marketing efforts which are already delivering against our goals of driving guest count, boosting our check average, and deepening our engagement with guests. In addition, we had a very strong publicity campaign around the Share the Love promotion resulting in appearances on programs such as Dr. Phil and Entertainment Tonight. The visibility we gained from this caliber of media coverage highlights our brand and publicizes what’s new in our restaurant. Our cost initiatives are also contributing to our performance. We realized over $4 million in savings during the first quarter, and we expect our initiatives to continue to deliver savings throughout the rest of the year.

Our financial position is strong, and we are on track with our goals to reduce our debt his year. We repaid $25 million of the $275 million balance on a revolving credit facility in the first quarter while increasing our cash balances from year end levels.

Finally, some comments on development. We opened one new restaurant during the first quarter as planned in Walnut Creek, California. We’ve talked about the softness that we’ve seen in California over the past 18 months or so; however, Walnut Creek has been open for just over 2 months and is averaging about $300,000 in weekly sales. This is incredibly strong performance in normal economic times, let alone in a recession. The takeaway here is that although any market can experience softness, there is usually varying performance within that market. I think the Walnut Creek location also illustrates the strength of our brand and underscores the value of premier locations.

Our smaller Annapolis location is performing very well. For those of you who are newer to the Cheesecake Factory story, the Annapolis location is the first of our new 8000 sq ft restaurants. It was built at an investment cost that is more than 20% lower than our 10,000 sq ft model, but has the potential of delivering $200,000 in average weekly sales. Annapolis is living up to its potential, and we continue to be pleased with its performance. In terms of development for the remainder of the year, we expect that we will open at most one additional restaurant. This reflects the current expected opening dates for the development in which our restaurants will be located.

In summary, our team did an excellent job of executing our strategy this quarter. Our performance was the result of collaboration across our entire company, from operations to finance. There is still more work for us to do, and we believe that the continued focus on brand enhancement, guest experience, and prudent financial management will help us to continue to drive solid performance.

Now, I’d like to turn the call over to Doug to review our results and discuss our outlook for this year.

Doug Benn

Total revenues at The Cheesecake Factory for the first quarter were basically flat, at $392.8 million, reflecting flat year over year restaurant revenues and a 13% decrease in bakery revenues. Restaurant revenues reflect a 4% increase in total restaurant operating weeks, primarily from the opening of 8 restaurants during the trailing 15-month period, offset by an approximate 4% decrease in average weekly sales.

Overall comparable sales at The Cheesecake Factory and Grand Lux Café restaurants decreased 3.4% for the quarter. By concept, comparable sales decreased 3.2% and 5% at The Cheesecake Factory and Grand Lux Café respectively. Comparable sales benefited from the New Year’s holiday shift during the first quarter, and we gave less back at the end of the quarter than we expected in relation to the Easter and spring break shifts.

At The Cheesecake Factory, while comparable sales were still softer than we would like in general, the pressure was slightly pronounced in the West, particularly in California and Arizona. This is a continuation of the geographic trends we’ve seen over the past year. At Grand Lux Café, about 70% of the comparable sales decline came from our one unit in California and our three units in Florida, again a continuation of the trends that we’ve seen in previous quarters.

Moving on to our bakery operations, third-party bakery sales decreased 13% in the first quarter to $13.1 million versus $15.1 million in the prior year quarter. In the first quarter of last year, we had long post-holiday shipments to the warehouse clubs which did not recur this year. The club stores are being careful with their inventory as customers are purchasing fewer discretionary items in light of the economy.

Cost of sales decreased to 25% of revenues for the first quarter of 2009, compared to 25.6% in the same quarter last year. The 60 basis point decrease was solely due to improvement in our restaurant cost of sales, and most of the decrease within restaurant cost of sales was the product of our development of the small plates and snacks and specials menus which have lower food costs. In addition, cost of sales improvement stemmed from favorable commodity costs primarily related to produce, cheese, and meat. The remainder resulted from changes in vendor selection and consolidation and efficient management in the size and frequency of our orders.

Total labor was 33.9% of revenues for the first quarter, up 20 basis points from 33.7% in the prior year. We experienced higher health insurance in the first quarter of this year as we lapsed some favorable claims activity in the first quarter of last year. Our direct operating labor absent this health insurance increase was actually about 75 basis points better than the first quarter of last year. Half of this improvement came from labor efficiencies resulting from fewer new restaurant openings in the fourth quarter of 2008 versus the fourth quarter of the prior year. The other half of the labor savings was made possible by the roll-out of our kitchen management system as well as changes to our manager staffing level.

Other operating costs and expenses were 25.9% of revenues for the first quarter of 2009, which is up from 260 points from 24.3% reported in the first quarter of last year. Approximately 50 basis points of this increase resulted because of favorable adjustments to our Workers’ Compensation and general liability self-insurance reserves in the first quarter of last year. An additional 50 basis points of the increase came from incremental marketing expenses in the first quarter of this year, and the remainder of the roughly 60 basis points represent continued sales deleverage. While the deterioration in other operating costs and expenses has improved, we will continue to focus efforts here to get comparisons closer to flat with the prior year.

G&A expense for the first quarter was 5.5% of revenues, up 30 basis points as compared to the first quarter of 2008. The majority of the increase came from an accrual for corporate bonuses this year versus no accrual last year as well as higher costs associated with our retail gift card program.

Depreciation expense was 4.7% of total revenue for the first quarter, compared to 4.6% for the first quarter of 2008. Pre-opening costs incurred during the first quarter were $1.7 million, compared to $2.5 million in the same quarter last year. As expected, this decrease resulted from our reduced opening schedule in the first half of this year relative to last.

Interest expense included $4 million of expense on the $275 million in debt we had outstanding under our revolving credit facility during the quarter. This compares to $2.6 million in interest expense in the first quarter of the prior year. The increase in interest expense reflects the higher rate that went into effect in conjunction with the amendment to our credit facility in January of 2009. In addition, our average debt balance outstanding was higher in this year’s first quarter than last year.

Our effective tax rate for the first quarter was 22.8%. The decrease from the prior year first quarter was attributable to a higher proportion of employment related tax credits in relation to pre-tax income.

Our liquidity position continues to be solid. As David mentioned we increased our cash and marketable securities balance from year end level to $89 million at quarter end, while at the same time using $25 million to pay down our revolving credit facility. The balance on our 5-year revolver is now $250 million. The credit facility is in place until April 2012, and although we have no principal payments due prior to that time, our plan continues to be to further reduce our debt this year in the second quarter and during the second half of the year.

Our cash flow from operations for the first quarter was $41 million, and net of $11 million in CapEx, we generated approximately $30 million in free cash flow during the quarter.

That wraps up our business and financial review for the quarter. Now, let’s spend a few minutes on our outlook for the second quarter and the remainder of 2009.

Visibility continues to be cloudy in this uncertain and oftentimes volatile economic environment, but we will continue to provide estimated ranges for diluted earnings per share based on comparable sales assumptions. We will also share some thoughts with you on directionally where we see our costs heading for the remainder of the year. As I said last quarter, while the EPS ranges we provide are our best estimate of where we expect to be based on factors known at this time, they are highly correlated to the assumed level for the comparable sales. As a result, I continue to urge you to consider our guidance to be more of a sensitivity analysis than an absolute prediction.

With that said, for fiscal 2009, we now anticipate diluted earnings per share between $0.67 and $0.75 based on the assumption that comparable sales will be in a range of between negative 3% and about negative 4.5% for the year. Although we have not made a definitive decision about our summer menu price increase, our comparable sales assumption for the year includes a placeholder of about 1% for the summer menu price increase. We would now expect our tax rate to be quite a bit lower than the 29% that we projected at the start of the year. We expect our full-year tax rate to fall between 24% and 25% as a result of employment related tax credit and a lower level of non-tax deductible deferred compensation expense. Our EPS range for the year of $0.67 to $0.75 includes about $0.04 benefit from this lower tax rate assumption.

For the second quarter of 2009, we expect diluted EPS between $0.19 and $0.21 based on an assumed range comparable sales figure of between minus 4 and minus 5%. This comparable sales assumption for the second quarter reflects pricing of approximately 2.2% currently in our menu. The $0.19 to $0.21 range includes $0.03 in expense related to the anticipated unwinding of an interest rate collar that is necessary because of our plan to pay off additional borrowings during the quarter.

Our current expectation is for food cost inflation in the 1.5% to 2% range, down about 100 basis points from our projection in February, reflecting a decline in commodity costs for some of our non-contracted items. With 60% of our commodities contracted on an annual basis, plus additional contracts in place that run 3 or 6 months, this is the best read today that we have on the level of the expected increase. With our assumed menu price increase for the year, we now expect cost of sales as a percentage of revenues for 2009 to be lower relative to 2008 levels.

We expect other operating costs to continue to driven higher by deleverage on the lower level of sales and a full year of marketing expense this year as well as the lapsing of favorable adjustments to our insurance costs in 2008. Excluding a projected 40 basis point benefit from lower pre-opening costs, we expect our operating margins in 2009 to be lower by 90 to 140 basis points as compared to 2008, depending on where we fall within our assumed range of comparable sales.

Our projection for capital spending is now expected to be between $40 and $45 million in 2009, of which about $13 to $16 million will be spent on development of new restaurants. As a result of the lower forecast of capital spending and higher expected earnings, we now estimate our free cash flow will be better than we last projected by about $15 million, resulting in an estimated $85 to $95 million in free cash flow this year. We plan to utilize this free cash flow combined with a portion of our cash on hand to reduce the outstanding balance on our credit facility. We now expect to pay off a minimum of $100 million of the revolver balance as compared to our previous estimate of between $75 and $100 million, which will bring our debt level down to $175 million by year end.

With that said, we’ll take your questions, and to allow us to accommodate as many questions as possible, please limit yourself to one question and then re-queue with any additional questions you have.

Question and Answer Session

Operator

(Operator Instructions). Your first question comes from the line of John Glass with Morgan Stanley.

John Glass – Morgan Stanley

Doug, could you please repeat what you said about the pressure in the labor line this quarter relating to that one-time health benefit adjustment, and is that a one-time this quarter or does that persist, and can you talk about where you think specifically labor goes this year? I think you said 75 basis points decline year over year. Is that something that’s sustainable at the current levels? Could that accelerate through the year as you implement more cost savings?

Douglas Benn

Let’s talk first about the quarter. The quarter labor is up overall by 20 basis points, but last year we implemented a new health insurance carrier, and anytime a new carrier is put in place, there is a lag effect on the claims coming in, and so that claims early on last year that came in and were booked into our expense were lower, and this year, we’re seeing a more normalized claims level. The comparison is negative here in the first part of the year, but we would expect that near the end of the year, possibly by the fourth quarter that maybe we’ll see some positive comparisons because our health insurance expense for the year last year was not unreasonably low. It was just low earlier in the year, and with respect to the labor line, we announced at the start of the year at our last conference call that we had about $5.5 million worth of labor related initiatives that had to do with the kitchen management system, manager staffing, etc., were well on our way. We claimed about $1.5 million worth of those this quarter, and we would expect to continue to claim some labor benefits throughout the rest of the year, and I would expect that labor for the year ends the year relatively flat, perhaps a slight improvement over the previous year.

Operator

Your next question comes from the line of Joe Buckley from Bank of America-Merrill Lynch.

Joe Buckley – Bank of America-Merrill Lynch

Just to follow up on that question, I think David mentioned $4 million of cost savings in the first quarter. It sounds like $1.5. It might have been on the labor line. Could you run through some of the other costs programs, and then maybe also I think you indicated food costs will be down, labor flat to maybe down, but operating margins still under pressure, so maybe talk about that other operating expense category and what pressures you’re seeing within that category of costs.

Douglas Benn

In addition to the labor cost savings, during the first quarter, we’ve identified a number of other cost savings for the year, a lot of them in the cost of sales area. The development of lower food cost items with the small plates and snacks and the management of our supply chain and our order quantities are really going to be, had been already in the first quarter and will continue to be a big savings for us. The other operating expense line is where most of the pressure is, and we do have some savings initiatives that we have put in place there that we’re going to realize during the rest of the year. A good example is in the repairs and maintenance area where we’re just doing a better job of paying attention to that. It is being controlled by one person. We’re being more prudent and reasonable about the way that we’re doing our repair and maintenance expenses, so if you look at our operating margin overall, we expect it again to be under pressure for the year as a whole with food costs down, labor flat, and again other operating expenses are where the pressure is going to come from, and some of that is marketing, but some of that is just the deleveraging that we’re seeing, but that’s the area where we’re concentrated the most right now.

Operator

Your next question comes from the line of Jeffrey Bernstein – Barclays Capital.

Jeffery Bernstein – Barclays Capital

Based on your own guidance for the first quarter, it looks like you beat by about $0.07 from the mid point, and I think you said the tax rate is now going to help you by $0.04, so you’re talking about perhaps $0.11 of upside to what you think your prior full year guidance was. It looks like you raised your full year guidance by about $0.10, so it seems to be roughly a wash, but yet I would think two things. One, the comps are better, or at least your guidance for the full year seems to be better than what it was last quarter, and I would think some of the cost saving opportunities that you experienced in the first quarter you would see some continuation of that for the rest of the year, so I’m just wondering if you can kind of piece those things together whether or not I’m missing something or whether this guidance for the rest of the year is somewhat conservative at this point.

Douglas Benn

I think you’re only missing once piece. If you take the $0.10 change in our guidance, $0.06 represents the upside from the first quarter as you said, $0.03 or $0.04 represents the taxes, and then we’re factoring in about an additional $0.03 for better than what we expected before performance either in comps or cost savings or whatever, but that’s offset by the $0.03 that we’re going to take in expense in the second quarter relating to the unwinding of the swap, so I think that brings it together, at least it brings it together in my mind. If you take $0.06 and you add $0.04 in tax benefit and then $0.03 for better than expected performance and then subtract $0.03 because we’re going to unwind the swap, you’ll get about the $0.10 that we raised the guidance by.

Jeffery Bernstein – Barclays Capital

So the $0.03 that you represented the comp and/or cost savings, I guess it’s there, where I would have assumed it would’ve been more just based on the cost saving benefit you had in the first quarter, and now you’re looking for the comps to improve by what looks like more than 100 basis points.

Douglas Benn

They’re probably meant to improve. If you look at it carefully, the comps are improving some over what our previous guidance was, so I’m really speaking to the incrementality if you will between what our previous guidance was and what it is now, so we’re not expecting comps to get significantly better than what our previous guidance was, and during the last part of the year, they were pretty robust. In the fourth quarter, we have to run pretty good comps. I think I talked about that in the call last time that there were pretty high expectations for the fourth quarter since our comps were so negative in the fourth quarter of ’08.

Jeffery Bernstein – Barclays Capital

Was there sequential improvement in the comps through the first quarter and into April?

Douglas Benn

There was. Let’s talk about that for a second. During quarter, basically our comps, we had a big improvement in our traffic, so we were minus 7% traffic in the fourth quarter and we were minus about 4.3% traffic in the first quarter, so traffic improved greatly. Our comps stayed relatively the same. If you take out the holiday shifts at the beginning and end of the quarter, our comps stayed relatively flat during the quarter. In other words, didn’t deteriorate or accelerate, and that flat percentage is about 4.5% down. That’s about what roughly a normalized week right now is running for us, and we ran only minus 3.4 in the first quarter, and part of that had to do with favorable holiday shifts, and we might’ve gotten a little bit of weather benefit out of that, so when we look at the second quarter, we basically 4 to 5, and that’s that 4.5%.

Operator

Your next question comes from the line of Steven Kron – Goldman Sachs.

Steven Kron – Goldman Sachs

Following up on that last point that you were talking about, the 4-5% guidance that you’re giving for the second quarter, that seems to be what you’re running at now, do you think of that as kind of deceleration versus what you saw in the first quarter? I understand there was a calendar shift, but you’re starting to cycle over much easier levels from last year. Maybe you can first comment on that and maybe quantify the calendar shift that you saw at the end of the quarter that might be influencing the beginning of April as well, but my question was more targeted towards the small plate items that seemed to drive some success there. Can you maybe talk a little bit about it as far as what mix you saw in your menu, and if I understood correctly, the targeted marketing is going to towards that in the second quarter, so should we expect the same 50 basis points of marketing expenditure in the second quarter as well?

Douglas Benn

Small plates and snacks are obviously doing very well for us. It’s obviously a way to provide our guests with different price point items and give them greater value. We’re getting very good frequency for use of those items. In fact, one of the advantages of them is the higher check average that they’re currently commanding, and they’re also driving our cost of sales lower, so that’s what’s so exciting about this menu category for us, in addition to giving a great new choice to our guests with a value perception.

Steven Kron – Goldman Sachs

What’s the mix on your menu at this point? What percentage of the sales are on those small plates?

Douglas Benn

I don’t know that number.

David Overton

We’re selling thousands of them. We can get that number, but we don’t have it right now.

Douglas Benn

It’s enough to make about a 40 basis point difference positively on our cost of sales.

David Overton

Plus we have special menu in each restaurant, or at least in 100 of them, where there are about 8 or 9 items that are priced well, but they had a great food cost, and they’re being ordered very intensely, so combine that with the small plates and snacks, and that’s what’s contributing to the lower food costs and then within the next couple of weeks, we have another 40 restaurants that will be rolling out a special menu that didn’t have them yet, so that should help a little more as well.

Douglas Benn

With respect to lapping around the easier sales comparison, that really doesn’t happen until near the end of the second quarter. The first part of the second quarter, after you get through the first few weeks is pretty tough. We were still doing relatively well the second half of April and all of May last year, so the comparisons don’t really get easier until June, and at the end of the quarter, I said we didn’t get hit quite as hard at the end of the first quarter as we expected from the shifting of the Easter and spring break holidays. That was only about 0.5% impact, so when we’re looking at the second quarter sales and trying to come up with what a reasonable same store sales assumption is for the second quarter, we wouldn’t expect a whole lot of benefit from it either. In fact, we know what it is. It’s been three weeks, and we’ve factored that into the guidance of minus 4 to minus 5 that we gave.

Steven Kron – Goldman Sachs

Did I hear you correctly that this quarter you will have the targeted marketing towards the small plates, and should we expect the same 50 basis points?

Douglas Benn

We have mentioned that, so there are a couple of cards in there. One is as we did in the last quarter, to have some cheesecake, come in for an extra visit, and then we also gave an extra card in there to come in and get a little deal on a small plate snack because we thought it was helpful, so we really sort of doubled down with this one. I think it’s a great offer, plus we have some internet web-based offers and prices and things. There was a marketing piece that came out today. You can look at that for some more details or go to the web site, but that is what we’re going to be focusing on from the second quarter.

David Overton

There’s a press release that went out today that’s very detailed about the second quarter.

Operator

Your next question comes from the line of Sharon Zackfia with William Blair.

Sharon Zackfia – William Blair

I just want to be a little clear on the guidance for the second quarter. Understanding that your comps get easier in the month of June, are you running a little bit worse than the negative 4 to negative 5, and you’re assuming it gets better, or are you running within that range and you have the opportunity for it to get better against easier comparisons?

Douglas Benn

We would look at our base same store sales right now as being about minus 4.5%, if you take out holiday shifts. We’ve completed three weeks of the quarter. After three weeks of the quarter, we’re running better than minus 4 to minus 5%, but we have to be running better than minus 4 to minus 5 because of the fact that we did have some benefit from the Easter and spring break shifts, so we’re looking at the quarter as if the next 3 to 6 weeks are pretty tough comparisons. So we probably will be under. We would expect that we would be probably worse than what trend line run rate is. This is not an absolute prediction obviously, and that’s what I said at the start. We do the best job we can of taking into account all of the factors that go into this, and when we do that, we get minus 4 to minus 5, but we’ll see. We’ll know a lot more after the next 4 to 6 weeks is up, and then it will get a little easier in June.

Sharon Zackfia – William Blair

Understood. I just wanted to make sure you were running ahead of that with the Easter shift at this point. Getting to better questions, on the marketing spend, are you actually changing the amount of marketing spend this year or just the way you’re spending the money, and I’m thinking of that as a percent of sales?

Douglas Benn

We’re changing the amount of the marketing spend. We had very little if any marketing spend last year.

David Overton

Mark just came on board in the middle of the year, and it took him those months to get settled, so now we’ve given him a budget and he’s working within that budget.

Sharon Zackfia – William Blair

Did you say already what the goal is as a percentage of sales for marketing spending this year?

Douglas Benn

About 0.5%.

Sharon Zackfia – William Blair

I want to make sure I understand the labor. I think you mentioned $5.5 million in labor initiatives. Was that just an annualized number, and you’re saying that you’ve captured $1.5 million in the first quarter? Did I understand that correctly?

Douglas Benn

That’s exactly right.

Sharon Zackfia – William Blair

I understand why you slowed growth in this environment. I think everyone appreciates that. I guess I’m curious as to where your new unit returns are returning for the class of ’08 or the one that you’ve opened so far this year, and how you think about the long-term opportunity for Cheesecake Factory, what would be the triggers for you to reaccelerate growth? If you could kind of walk us through maybe the longer term thesis at this point and the returns you’re getting on the units.

Douglas Benn

The one that we opened this year is going really well. It’s in California, which we’ve said is one of the weaker markets, and it’s in Northern California and doing close to $300,000 a week. In fact the last three that we’ve opened are all doing very well. They’re all $200,000 to $300,000 restaurants.

David Overton

We never turn down an A site. We’re being more particular now than we were let’s say when we were opening 22 to 23 stores in ’06 and ’07, but there’s no great site that we’ll turn down today. There are at least a dozen sites we’re looking at right now for 2010, and I don’t know how many we’ll get. A lot depends on the economy, the strength of those sites, and will all those deals get done. A number of the sites that we’re going to open this year, it was landlord’s choice to hold them to 2010 and some may even go into 2011, most because most of the tenants, the retail tenants and other tenants, asked these landlords to hold off these sites, so they didn’t have to drop out, so there’s still growth, and I for one am always on the hunt for great sites. We have some sites that are doing extremely well, as Doug just mentioned, and then as the economy gets better, I think Sharon, we’ll consider picking it up even more.

Douglas Benn

Sharon, one of the big things that I would say from a development standpoint, one of the opportunities that we have to expand our brand in the future has to do with the success of the new smaller format restaurant that we talk about a lot in Annapolis, Maryland. We’re surprised by the amount of sales it can do. We were hoping that it could do $8 million in annual sales. Actually that 8000 sq ft format can do $10 million in sales, so at a lower investment cost of about $1.5 million for that restaurant, the propensity or the chance for that unit to generate great returns in many expanded number of locations from the larger format is great.

Sharon Zackfia – William Blair

Just to be clear, in 2010, I know it’s early, but we should at this point expect development to accelerate again? Do you expect you’ll open more than two?

David Overton

I can’t make you any promises, but the answer is yes, that we would expect it.

Operator

Your next question comes from the line of Jake Bartlett with Oppenheimer & Co. Please proceed.

Jake Bartlett – Oppenheimer & Co

You mentioned that California and Arizona were still your weakest markets. I’m wondering whether they improved more than other markets in the quarter. Would that be a source of all the upside versus your expectations for sales?

David Overton

One of the things that we’ve talked about is urban versus suburban markets before, and the urban markets are still performing better than suburban markets, but part of the upside we saw during the quarter was a little bit of the closing of the gap on suburban markets. Urban markets are still performing better, but suburban markets stepped up the game a little bit, if you will, so it’s not so much of California versus Florida versus Arizona. Where we saw the change was suburban markets got a little bit better.

Jake Bartlett – Oppenheimer & Co

Just to try to delve in more into the comp. In the first quarter, I believe you mentioned that the traffic was fairly consistent throughout the month, but I’m wondering whether there was any relation to the rollout of the new menu, whether there was any marketing variations that would have made it improve throughout the quarter.

David Overton

If you look at our 3.4% negative comp for the quarter, basically 2.2% pricing in the menu, and there is a 1.2% negative menu mix shift and about 4.2% negative traffic. The traffic improvement, it’s a little hard to tell because in the first part of the quarter we saw the shift from the New Year’s holiday, but I don’t think that it was marketing related. The facts are that basically we saw pretty flat performance throughout the quarter and not an improvement or deterioration.

Jake Bartlett – Oppenheimer & Co

I guess the interesting part is that others don’t seem to have seen that trend, so it’s particular.

David Overton

The marketing program did work for us. The small plates and snacks helped us a lot. We had better execution. I think that we really tried to hone in and make the execution of our restaurants better. It’s hard to tell what helps at what point in time, but all those things are contributing.

Jake Bartlett – Oppenheimer & Co

One thing that might be helpful, just so that I have it clear what you are lapping for traffic in the second quarter, so what was the traffic in the first and second quarters of ’08?

David Overton

The traffic, I have same-store sales in the first and second quarter of ’08, and let’s get together offline on that. I don’t know the traffic numbers.

Operator

Your next question comes from the line of Destin Tompkins – Morgan, Keegan & Company.

Destin Tompkins – Morgan, Keegan & Company

I was trying to understand if the small plates and new menu was in the system for the full Q1, how much it contributed to Q1 both same-store sales and the cost of sales improvement, and then should we expect a full quarter’s benefit in Q2? Can you kind of clarify the timing of the rollout?

Douglas Benn

Yes. It was all in by the end of the quarter, but it was in for most of the quarter and had about a 40-basis point positive impact, that and the specials menu together had a 40-basis point positive impact to cost of sales.

Destin Tompkins – Morgan, Keegan & Company

So you saw benefit to cost of sales, and I think you also mentioned that you saw better average check with it as well.

Douglas Benn

Yes. We had better average check, and we had more profit from every dollar collected, so it’s all good.

Destin Tompkins – Morgan, Keegan & Company

And the negative mix that you mentioned, how do we reconcile those two?

Douglas Benn

Well, there are other items on our menu other than small plates and snacks. Actually the mix improved. In the fourth quarter of last year, our mix was impacted negatively by about 2.5%, and this quarter only negatively impacted us about 1.2%, and basically we still have lower incidence of people order beverages, both alcoholic and nonalcoholic beverages. However, part of the reversal was the dessert incidences are now up, so we have people ordering desserts again, which helped close that gap a little bit.

Destin Tompkins – Morgan, Keegan & Company

In terms of how much it was place for Q1, it was maybe in place for half the quarter. Is that a good rule of thumb?

Douglas Benn

Probably maybe about that. The special menu was in a little longer, and the small plates took a little longer to roll out.

Operator

Your next question comes from the line of Brad Ludington from Keybanc Capital Markets. Please proceed.

Brad Ludington – Keybanc Capital Markets

In the release you’d mentioned that you are further working I think on supply chain initiatives or optimization of the supply chain. Can you give some color on what those initiatives are that could lead to further benefit there?

Douglas Benn

We are talking and looking through every few that we have and trying to make a determination without impacting our guests in a negative way or reducing our quality if there is a better way to order a product either by the quantities we order it, the amount of times we have it brought to our restaurant, the size of the containers, etc. Those types of things are what we are looking at, and we think all those things together can be a pretty big number for us.

Operator

Your next question comes from the line of Bryan Elliott with Raymond James.

Bryan Elliott – Raymond James

Just a clarification on the small plates and snacks that you just did. They were in by the end of the quarter but the specials...

David Overton

There is still some more runway to go on that. That specials menu was not in every restaurant. The restaurants that it was in, it was for the whole quarter, but there were about 48 restaurants that it was not in that it is going to go into, so part of what we are looking at and going forward in our savings on the cost of sales front is from that specials menu being in another 48 restaurants.

Bryan Elliott – Raymond James

And that was held back from those 48 so you could have a sample or control group to test?

Douglas Benn

It was just the way that we decided to roll it out. We broke the rollout of that, went with the small plates and snacks knowing that we could pick that up later.

Bryan Elliott – Raymond James

The 40 bps on the food side from the mix shift and the benefits of those two combined, I assume that wasn’t 40 bps in Q1, that’s 40 bps in the restaurants that have had it in, and that’s what you are seeing once it’s fully in and the customers are ordering, correct?

Douglas Benn

That was impact in the first quarter.

Bryan Elliott – Raymond James

So if you systematize that, given that it wasn’t fully in, either was fully impactful for the whole first quarter, then it might be more than 2x that number once we are fully rolled out, would it not?

David Overton

I wouldn’t go there with that.

Douglas Benn

I think it could be a little better, but I think that’s way too much.

Bryan Elliott – Raymond James

If it was 40 bps in the whole first quarter and it was a minority of the store weeks, why when its 100% of the store weeks, would it not have a commensurately larger impact.

David Overton

I wouldn’t say it was in a minority of the store weeks. The answer to that question on when the small places and snacks menu went it and being specific about is not something where we’re 100% prepared to answer. I would tell you that we’ve taken everything into account for the quarter and for the year, the second quarter coming up and for the year, and that I would lead you to believe that I think our cost of sales for the year can be up to 60 basis points better than what they were last year.

Operator

Your next question comes from the line of Rob Weiler with Piper Jaffray.

Rob Weiler – Piper Jaffray

At the end of fourth quarter, it looks like the leverage ratio was about 1.55 times. Can you give us an update what it was at the end of first quarter?

Douglas Benn

Sure. It was 1.47.

Rob Weiler – Piper Jaffray

On the fixed charge, what was it at the end of the quarter?

Douglas Benn

It was 2.28, which was well over the minimum of 1.9.

Rob Weiler – Piper Jaffray

On the pre-opening costs, what are those tracking at now? I just seems like they are a lot higher. You only open one store in the first quarter, so can you give a little more on pre-opening?

Douglas Benn

That was pre-opening, and I think that also in that number is some of the manger bench strength that we keep. We’ve cut that back some because of the number of openings we are doing, but some of the pre-opening costs relate to that, and I don’t know if that makes up the entire difference that you are seeing but that’s what I would say.

Operator

Your next question comes from the line of Colin Guheen with Cowen and Company. Please proceed.

Colin Guheen – Cowen and Company

So what’s a good level of pre-opening for this year given that you are not opening units so there might be some other costs in that line.

Douglas Benn

Well, a good level of pre-opening for the entire year would probably be somewhere, like last year, it ran around $11.8 for the year, and this year I would say for the year somewhere in the neighborhood of $5 million to $5.5.

Colin Guheen – Cowen and Company

Does that include an assumption of having some of next year’s unit openings?

Douglas Benn

That would. We said up to one more additional restaurant, we don’t really know if that’s going to happen because we are not in total control of that, but it would also include some of the restaurants that David mentioned that hopefully we’ll be able to open in the first quarter of 2010, some pre-opening costs for that, but it’s all assumptions obviously, but we have assumed something for that.

Colin Guheen – Cowen and Company

Can you just talk about the bakery sales and how those are trending outside of this quarter and what kind of impact the destocking at the club stores might have?

Douglas Benn

Well, they were down this quarter obviously. The warehouse clubs again are being very careful with their orders and their inventory levels, and so that’s why we are seeing the pressure if you will from third party bakery sales, and we would hope to have that pick up. We are working on that, but that’s big. Third party baker sales are highly dependent on our club business.

Colin Guheen – Cowen and Company

So, it could be fair to see them down for a few more quarters or just modestly?

Douglas Benn

It could. I would probably expect to see them down for at least the next few quarters.

Operator

Your next question comes from the line of Christopher O'Cull with Suntrust Robinson Humphrey. Please proceed.

Christopher O'Cull – Suntrust Robinson Humphrey

I can appreciate the interest in opening restaurants, but I guess the longer term question here. When you look at your operating margin this year hovering around 5%, and you go back and look at where you were a few years ago, 500 to 600 basis points higher, what’s changed other than obviously declining guest counts that would prevent you from being able to recover a lot of that margin?

Douglas Benn

You are asking a good question. The difference between where we are today and where we were is very much a matter of same-store sales growth. The bad news about declining same-store sales environment is there is deleveraging that really hurts you. The good news when it’s going the other way is leveraging works both ways, so I would expect we may not get 500 or 600 basis points back, but we can certainly get a good bit of that back once we can do a good enough job where we earn those guests coming back in our door in a positive comparison format, so if we get the same-store sales back to 3 or 4%, which I think we can do over the longer term as soon as we get out this economic issue that we are in, I think you are going to see some nice expansion in the margins.

Christopher O'Cull – Suntrust Robinson Humphrey

When you think about development, longer term even, do you anticipate expecting development in concurrence with margin recovery? So if margins are continuing to decline, we shouldn’t anticipate any kind of development. It would really come when start to see margin recovery, is that fair?

Douglas Benn

That’s pretty fair. I think rather than margin recovery I would say sales. Now as David said, we are not going to pass on A sites.

David Overton

When you have restaurants that are still doing $10, $12, $14 million that you’re opening, as long as you can continue with those kinds of sites, they are going to help us come back, but we are just going to be very particular, so I think we can have some growth with our A+ sites as well as continue to try to improve margins.

Christopher O'Cull – Suntrust Robinson Humphrey

Let me move on to the small plates. David, I know that small plates menu has only been out for a short period of time, but first has back of the house had any issues executing the additional items? My experience has been, I go in and order a couple of them especially the snacks, had there been additional issues for the back of the house with lines?

David Overton

Right now I think we have that pretty well. We are looking at our food production times all the time in each restaurant to make sure that it doesn’t slow it up. We work on it, so I think we’ve scheduled all the restaurants with the appropriate cooks at the right time to get those out. So far, I have no report of anybody struggling to do that, and I think we’ve nicely worked it in to the flow.

Christopher O'Cull – Suntrust Robinson Humphrey

When you look at the summer menu rollout, is the plan to still keep that menu separate from the main menu?

David Overton

I think for right now, yes. We have another 6 or 7 that we want to substitute tasks that I think are even better, so we are going to expand that section just a little bit and replace let’s say the bottom two or whatever just to keep it new and fresh, and I think that because it’s separate, there’s a lot of intensity going to that, to the ordering of that and the special menu, so for a while longer, we’ll keep it separate. At some point, it’ll probably have a page of it’s own but not just yet.

Christopher O'Cull – Suntrust Robinson Humphrey

Okay, thanks guys.

David Overton

Thank you every one.

Operator

Thank you for your participation in today’s conference. This concludes your presentation.

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Source: The Cheesecake Factory Inc., Q1 2009 Earnings Call Transcript

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