The Cheesecake Factory: Have Your Cake and Eat It Too

The Cheesecake Factory: (CAKE) June 12, 2008 close: $17.36
52-week range: $17.24 [Jan. 22, 2008] - $28.24 [Aug. 9, 2007]

The Cheesecake Factory operates 154 casual dining restaurants including 13 larger and more upscale Grand Lux Café units. Third party bakery sales including Costco (COST) account for about 5% of sales.

CAKE is a former high-flying growth stock that was loved by all while it traded at extremely high valuations. It earned that status by taking EPS from [split adjusted] $0.10 in 1996 to $1.09 in 2005 with higher earnings in each year along the way. During most of that run, Cheesecake Factory commanded P/Es of 28x – 36x. Even now its 10-year median multiple is 32x.

The economic slowdown along with higher food and labor costs, have stalled earnings since 2005. EPS dipped to $1.02 in 2006 before nudging back up to $1.04 last year. Despite a year-over-year dip in Q1 earnings it is expected that CAKE will show a full year increase to $1.13 in 2008. Analysts see continued share buy backs and menu price increases leading to $1.29 per share by 2009.

Since 2004 the total outstanding shares will likely have been reduced from 77.93 MM to an estimated 65 MM by the end of this year. Long-term debt is just 34% of capitalization and total interest coverage was about 11x even after the share repurchases.

The shares closed today just twelve cents above their January nadir making the current valuation the lowest ever. At today's $17.36 they trade at just under 15.4x this year's and 13.5x 2009 estimates. That's less than half their old [overpriced] median. Today's price is lower than the lows touched in the entire period 2003 – 2007. Since the end of 2002, trailing EPS are up 58%, book value is plus 46% and cash flow per share has risen 113%.

Some well respected managers hold large positions here. As of the April 2008 proxy:

• Baron Capital held 10.6%

• T. Rowe Price owned 6.8%

• Merrill Lynch had 5.0%

• Officers and Directors hold about 6.8%.

What would be a reasonable target price for Cheesecake shares?

Even an 18 multiple on the 2009 estimate of $1.29 would bring these shares back to $23.22 or up 33.7% from present quotes.

By then we should be seeing signs of an economic revival. It wouldn't be surprising to end up seeing much higher expectations and a return to a 20+ P/E on growing earnings and a smaller share count.

That $23.22 goal price seems very attainable as CAKE shares hit $24.20 - $39.30 at their peak prices in each calendar year from 2001 through 2007. They were $23.30 as recently as March.

Using the Peter Lynch method of analysis… I liked it when I had to wait for a table recently. Annoying as a customer, but music to my ears as a share- holder. Not a bad thing regarding bar sales either.

With Cheesecake near six-year lows and at the cheapest valuation ever, I am a buyer right now.

If you like this idea but aren't sure about the timing… consider this low-risk combination play:

……………………………...………….…..cash outlay …..…cash inflow

Buy 1000 CAKE @ $17.36 ……………... $17,360

Sell 10 CAKE Jan. $17.50 Calls @ $2.30 ……………………… $2,300

Sell 10 CAKE Jan. $17.50 Puts @ $2.20 …………………….$2,200

Net Cash Outlay ………………………….$12,860

If Cheesecake closes above $17.50 on expiration date [Jan. 20, 2009]:

• Your shares will be called [sold] for $17,500.
• Your puts will expire worthless [a good thing for you as a seller].
• You will own no shares and have no option obligations.
• You will have a profit of $4,640 on your original cash outlay of $12,860. That's a 36% cash-on-cash return over the next 7 ½ months on shares that only needed to go up by 1% from your starting point.

Risk? Your break-even on the shares is the $17.36 cost less the $2.30 call premium = $15.06 /share. Your break-even on the puts is the $17.50 strike price less the $2.20 put premium = $15.30 /share.

Your overall break-even is thus $15.06 + $15.30 / 2 = $15.18 /share.

You could absorb a drop of $2.18/share or (12.5%) from your purchase point without incurring a loss.

In a worst case scenario you will own 2000 shares of CAKE at an average price of $15.18 /share. That's lower than the lows at any time since just after the 9/11 attack in 2001.

Disclosure: Author is long CAKE shares.

Comments

[Moby Waller]

First ... selling naked put options requires very high margin requirements, so this trade will tie up a lot of your available trading capital in most people's accounts for a long time (7 months) and option approval level.

Second... if CAKE drops to say 10 for example, for whatever reason, you will lose $7k on the stock and $5k on the puts, roughly a 100% loss -- so its not quite as risk-free as you indicate.

But I did find the article and strategy interesting. I've developed a new credit and debit spread strategy service with limited risks on all trades. Check my website for further info.

[Paul Price]

You can only invest going forward.

I love this stock from today's price point.

[Paul Price]

At the current valuation CAKE has significant upside and little downside.

The combo described reduces the break-even point even more.
If you don't like it, buy something else.

[bearfund]

Tell me Paul; is there a restaurant chain you don't like this strategy for? If I were as bullish as you are - and have been - on these stocks, I wouldn't bother with it; I'd just buy calls. Of course, I'd also have lost every dollar invested, which suggests that bullishness isn't justified. Someday you'll be right but it might be 50 years before these stocks regain the valuations they had when you first started pumping them. Or never.

The options strategy is not a bad one although as Moby points out writing naked puts ties up capital. Still, given the limited upside I have to be quite confident that the bottom is in and the company won't fail. Clearly you haven't done well on that score thus far. Might be a better play with a company like C that is for all practical purposes part of the federal government now. For example, buy C and write the 20 Jan'09 straddle, total cost $14.80. If the stock is lower than that you can bet all hell's broken loose so maybe pick up a GLD 100 call for $2.90 to complete the hedge. See, there, I'd feel pretty confident. CAKE ain't C though.

[Paul Price]

If you understood my posting you'd see that the combination play works even if the shares stay flat or even go down a bit.

That cushion negates much of the 'headwinds' and , in my view, the extremely low valuation of the company more than offsets any macro-economic negatives.

You are free to disagree. Don't buy if you think something else looks better.

I rarely, if ever, buy options. I want time decay to be working for me, not against me.

[truthinvesting]

Paul do you wish you wouldnt have recommended this on another website Cheesecake Factory [NDQ:CAKE] October 16, 2007 close: $23.23

Despite high gas prices and a weak retail environment Cheesecake Factory is likely to post record earnigns of around $1.12 this year versus EPS of $1.02 in 2006. The current concensus estimate for 2008 is now for earnings to hit an all-time record $1.33 on over $1.7 billion in sales.

Or do you think it was still wise to recommend this last fall?

[Paul Price]

I liked it then and I'm buying more now.

[ari5000]

Don't even know where to begin -- when oil is $5/gallon -- I can't imagine sitting down and paying 10 bucks for a piece of cake and coffee. 18x earnings? Try 10x and earnings will likely be lowered for years. No thanks.

[Emerson]

Thanks for the article. By the way, it's 'Eat your cake and have it too.'