Get Your Just Desserts by Selling Cheesecake Factory Puts

The Cheesecake (CAKE) factory operates 160 upscale casual dining restaurants- 146 Cheesecake Factories, 13 Grand Lux Cafes and 1 Rock Sugar Pan Asian Kitchen. They also license two limited-menu bakery café outlets. Their baked goods are sold through their restaurants as well as through third party outlets.

From its founding year of 1978 right through 2005 the Cheesecake Factory did nothing but grow. Sales and earnings grew rapidly and consistently. Since then the weakening economy took its toll with a slight EPS drop off in 2006 and then a larger one last year before an expected partial rebound this year.

Here are CAKE’s per share (split-adjusted numbers) as reported by Value Line:

Year	Sales	C/F	EPS	B/V	Avg. P/E	Range
2001	7.53	0.79	0.53	4.04	34.6x	13.30-24.20
2002	8.70	0.96	0.64	5.07	36.2x	16.60-29.00
2003	10.11	1.12	0.75	5.98	31.5x	18.20-30.00
2004	12.44	1.36	0.88	6.97	33.0x	25.00-33.50
2005	14.94	1.68	1.09	8.22	31.1x	29.30-38.50
2006	16.81	1.72	1.02	9.09	29.0x	21.70-39.30
2007	21.86	2.03	1.04	8.14	24.5x	21.20-29.80
2008	26.89	2.10	0.82	7.57	19.7x	5.00-20.00

Sales and cash flow continued to grow during the past three years even as EPS declined. The company took advantage of the big drop in share price to retire more than 25% of the outstanding shares since the end of 2005 with just 60.069 million shares as of June 30^th versus YE 2005’s 78.83 million. This should help EPS rebound nicely once economic conditions start picking up again.

Even in today’s depressed conditions Zacks see 2009 – 2010 earnings of $0.92 and $1.04 respectively. At today’s close of $17.88 /share CAKE’s multiples at 19.4x this year’s and 17.2x next year’s estimates. While not absolutely cheap, those are historically low for this company as can be readily seen in the table above.

Cheesecake’s balance sheet is solid with no short-term debt and long-term debt at just 29% of capital. Total interest coverage is about 6x.

Morningstar and Standard and Poors carry ‘Fair Value’ estimates of $21 and $20 respectively. Value Line’s normalized P/E assumption of 19x would lead to a year-end 2010 price target of $19.76 based on the $1.04 estimate for next year. CAKE shares hit a September 21, 2009 high of $21.01 before pulling back to today’s price.

How do I play a stock that looks somewhat, but not radically, undervalued?

I sell LEAP puts to lock in nice potential gains while giving myself even more margin of safety. Here are some of the puts I wrote today along with prices that are reasonable to expect based on the $17.88 closing price.

Put Option / Strike	Premium /share	Net Price (if Put)	Discount to Close
Jan. 2010 $12.50	$1.35	$11.15 /sh.	37.6%
Jan. 2010 $17.50	$3.40	$14.10 /sh.	21.1%
Jan. 2010 $20.00	$4.80	$15.20 /sh.	14.9%
Jan. 2011 $15.00	$3.10	$11.90 /sh.	33.4%
Jan. 2011 $17.50	$4.40	$13.10 /sh.	26.7%
Jan. 2011 $20.00	$5.80	$14.20 /sh.	20.5%

You can be ultra conservative by writing (selling) the $12.50’s or ratchet up to $15 - $20 strikes for bigger potential gains if CAKE shares rebound to $20 or above over the next 15 - 27 months (depending on whether you choose the 2010 or 2011 expiration date).

No matter which puts you write you’ll have a decent margin of safety from today’s quote. If you leave the puts alone until expiration you will also get to defer any potential tax gains until April 15^th of the year following the expiration date.

Maintenance margin requirements on naked put writing are typically 20% of the net exercise price (assuming you keep the option premiums received in the same margin-type account).

Examples from the chart above:

Put Option / Strike	Net Price (if Put)	20% Margin Requirement
Jan. 2010 $12.50	$11.15 /sh.	$2.23 /share
Jan. 2010 $17.50	$14.10 /sh.	$2.82 /share
Jan. 2010 $20.00	$15.20 /sh.	$3.04 /share
Jan. 2011 $15.00	$11.90 /sh.	$2.38 /share
Jan. 2011 $17.50	$13.10 /sh.	$2.62 /share
Jan. 2011 $20.00	$14.20 /sh.	$2.84 /share

You could meet the above requirements with any combination of cash, t-bills or marginable stocks or bonds.

Summary: Cheesecake Factory is a high-quality stock trading at a moderate discount to fair value. A 12-month price target of at least $20 seems reasonable based on all past history and future projections.

Selling LEAP puts for 2010 and/or 2011 can provide for break-even points well below today’s close while bringing in from $1.35 to $5.80 /share in upside.

If you’re comfortable owning CAKE shares a net price of $11.15 - $15.20 you might consider selling these puts for excellent returns with not too much risk. Excepting the insane market period of 2008 – 2009, the absolute low trade on CAKE shares was $21.20 for the four calendar years 2004 – 2007. Even in 2002 – 2003 when EPS were $0.64 and $0.72 the shares never touched lower than $16.60- a level still well above the break-even point on all the suggested trades.

Disclosure: Author is long CAKE shares (bought earlier this year) and short CAKE puts from recent trades.

Comments

[DesertRat87:]

Don't you mean 2011 and 2012 instead of the 2010 and 2011 years specified? The prices match the 2011/12 years.

Oct 22 03:16 PM

[Paul Price:]

Yes, sorry for the typo. It should read 2001 & 2012.

Oct 22 03:56 PM

[Paul Price:]

Cheesecake Factory profit beats Street
Thu Oct 22, 2009 4:54pm EDT

LOS ANGELES, Oct 22 (Reuters) - Cheesecake Factory Inc’s (CAKE) quarterly profit beat Wall Street’s view, as cost controls and lower food prices helped shelter earnings from falling sales at established restaurants, sending shares up 2.7 percent.

The restaurant company, known for its big portions and extensive menus, said on Thursday third-quarter net income was $16.3 million, or 27 cents per share, up from $11.8 million million, or 19 cents per share, a year earlier.

Excluding charges, the company had a profit of 29 cents per share in the most recent quarter, beating analysts’ average estimate by 5 cents, according to Thomson Reuters I/B/E/S.

Total revenue fell 1.1 percent to $400.6 million. Overall sales at restaurants open at least 18 months fell 2.8 percent, on a 2.4 percent drop at Cheesecake Factory restaurants and a 6 percent drop at the smaller Grand Lux chain.

Shares of Cheesecake Factory rose to $18.63 in extended trading after closing at $18.14 on the Nasdaq.

Oct 22 05:07 PM