Usually, restaurant stocks are not something to get excited about if you are looking to hold the stock for awhile. The industry itself experiences over 90% failure, and the only real success story (from the perspective of making investors reliably rich) has been McDonald’s. Investors considering a restaurant stock find themselves in the following dilemma: Either the restaurant is the next big hot thing and the valuation goes to something crazy like 100x profits to price in many future years of growth already, or a company has fallen out of fashion and can only stimulate earnings per share by opening up new stores rather than making existing restaurants more profitable which usually leads to terminal growth in the 1-4% or worse (declining sales and a cheap private equity buyout).
And that is why, when I started to study the stock of the Cheesecake Factory, I was pleasantly surprised by what I saw. First, the balance sheet: Cheesecake Factory has no pension obligations, issues no preferred stock, and only carries $25 million in total debt. That is only 5% of the company’s capital, and could be paid off with three months of profits if management desired it.
What I really like is that the restaurant manages its growth—it is deliberately avoiding the risk of oversaturation that is often common in the industry. They are only 189 Cheesecake Factories in existence, not even enough to field four in every state. In addition to its namesake restaurant, shareholders also own 11 Grand Lux cafes and, as of two weeks ago, the Rocksugar Pan Asian Kitchen.
The competitive edge of the Cheesecake Factory’s business model is that it does not have to deal with many suppliers and other middlemen that take their cut of the food and lower the amount of profits generated for Cheesecake Factory shareholders. That is because the Cheesecake Factory has two bakeries that create the food so they can keep the profits in house. It is a dramatic advantage that helps explain why the Cheesecake Factory earns 19.7% returns on the total capital that it employs.
The other thing that catches my attention is that Cheesecake Factory increases same-store profits at a rate of around 4%. This is a metric that is often ignored in favor of earnings per share (and I don’t say this as a criticism because a non-manipulated earnings per share figure does tell you what your ownership position is doing) but is nevertheless important because it indicates a higher earnings quality—Cheesecake Factory doesn’t just rely on creating new Cheesecake Factories to grow, but creates new stores at a moderate pace and grows its profits at its existing stores.
The other thing that I like is that valuation is tolerable: It makes $2.15 per share in profits, and trades at $48 per share. That is 22x profits, which is not a sale but is not overpriced for a company that has grown cash flows at a rate of 13.5% annually over the past ten years.
Even though I think that someone buying Cheesecake Factory here will be satisfied with the results, that is not the reason I’m writing this article. To use Buffett parlance, I don’t Cheesecake Factory is the kind of stock that you would buy with your twenty punches. My interest in Cheesecake Factory has much more to do with the next recession and fall in stock prices that we will see. Medium-casual restaurants notoriously get whacked during recessions because the conventional wisdom emerges that people won’t have the money to go out and eat pricey food, and the stocks tend to fall much more than is warranted.
Just look at what happened to the Cheesecake Factory during The Great Recession. In 2008, the price of Cheesecake Factory stock was humming along in the mid $20s. Profits created by the company were $52 million. That was $0.82 per share. By 2009, the company’s stock tanked—it fell to a low of $6.80 as everyone thought that the end was near. Cheesecake Factory holders saw their net worth in the stock fall by 75%. Not many people can tolerate that, and that is why the wrong attitude towards the stock market absolutely ruin your life.
But for the true businessman or value investor, this is what would have been readily apparent: Margins at the company actually grew, because the costs of ingredients fell by a greater amount than the traffic at existing stores declined in 2009. Furthermore, Cheesecake Factory was rolling out 12 new stores (these things are years in the making and don’t get halted based on the temporary whims of the economy) so that the company’s actual profits grew to almost $60 million, or $0.97 per share. When people talk about the mania of the stock market in the abstract, this is a specific example of what I have in mind: A company growing its profits from $52 million to $58 million yet seeing a 75% decline in stock price.
One of the reasons why Warren Buffett has been able to act so decisively is because he studies the fundamentals of a company in good times, and keeps those results in the back of his mind as a sort of muscle memory. When the price of the studied stock falls 35% or more, it is easy to check in and compare the fundamentals to what you last studied. What makes Cheesecake Factory so interesting is that it does not use debt to build new stores and has a very conservative balance sheet, on the cusp of being debtless if it desired. The profits actually grew during the last crisis. The really substantial medium-term money that gets made in investing occurs when you sit on a pile of cash and then invest in the best-of-breed company that is deeply unpopular because it operates in an industry that doesn’t handle recessions well. For people that have 10% to 15% of their funds set aside for deep value investing or speculation, it makes sense to keep Cheesecake Factory stock during a recession in the back of your mind as a potential candidate.