Cheesecake Factory: A Decent Q2, But A Foggier H2 Outlook

Just over a year ago, I wrote on Cheesecake Factory (NASDAQ:CAKE), noting that while the lows were likely in for the stock at $26.00 and that it had a better year on deck, I saw the better opportunity being Capri Holdings (CPRI), which traded at barely ~6x FY2023 earnings vs. CAKE at ~11.0x. Since then, Capri Holdings traded 80% higher before being acquired by Tapestry (TPR) for a ~60% premium. In the same period, CAKE has struggled to hold on to any of its gains, underperforming its industry group (EATZ) and the S&P-500 with a negative year-to-date return. In this update, we'll revisit Cheesecake Factory following its improved Q2 results and see whether the stock is finally offering enough margin of safety as it heads into its Q3 results in early November.

Recent Results & Q3 Outlook

Cheesecake Factory released its Q2 results in August, reporting a 4% increase in revenue to $866.2 million on the back of 1.5% growth in comparable sales (2-year stack of 6.2%), and the company noted that comparable sales have beat industry peers since 2019. Meanwhile, quarterly earnings per share improved to $0.88 vs. $0.52, its average check was up 5.2% year-over-year, and the company opened three new restaurants in the period across its concepts while taking advantage of share price weakness to buy back ~280,400 shares at $30.15. However, while these headline results look solid, they are less impressive when accounting for the company benefiting from some of the highest menu pricing industry-wide at 10.6%, which translated to a 3.7% traffic decline at Cheesecake Factory restaurants.

Fortunately, North Italia posted positive traffic growth (massively outperforming the industry average at 1.6%) and 20% two-year stacked comp sales growth. However, this made up just ~10% of Cheesecake Factory's total system (33 restaurants out of 321 total restaurants) and most of the system has seen negative traffic growth. That said, there were other positive takeaways. For starters, restaurant-level margins improved materially to 15.3% (Q2 2022: 12.6%) with help from menu pricing and better-than-planned labor productivity. In addition, the company noted that staff retention is tracking well as are guest satisfaction metrics, suggesting that guests are pleased with the value/service they're getting even in the face of steep price increases year-over-year. And in terms of hiring, applicant flow has improved, as has the quality of applicants (mostly industry experience), with this being a benefit to training costs with a less steep learning curve.

Finally, Cheesecake Factory noted that it has launched its Cheesecake Rewards Program nationally and member enrollment has exceeded its expectations. In addition, average unit volumes continue to track well ahead of the peer average, with the company holding the #1 spot at $12.4 million ahead of other brands like Fogo de Chao, The Capital Grille (DRI), Texas Roadhouse (TXRH) and its own North Italia. And in regards to Q3 commentary, the company didn't break out comp sales expectations, but noted that it expects revenue of $835 - $855 million in Q3 (implying 8% revenue growth year-over-year at the mid-point), and shared that traffic is getting "pretty close to breakeven" from negative previously as of its Q2 Conference Call in early August. That said, while this was similar to commentary provided by most restaurant operators in late July/early August, traffic turned decidedly negative starting in mid-August and decelerated through Q3. Let's take a closer look:

Industry-Wide Trends

While many restaurant brands have gotten some help on the bottom line from a commodity standpoint after commodity prices remained elevated at double-digit levels across nearly all categories in 2022, the same hasn't been true from a traffic standpoint. In fact, traffic has been hovering in negative territory for the bulk of 2023 after a brief month in positive territory due to lapping easy comparisons from Omicron last year (January 2022). And while traffic was trending reasonably well in July after a tough start to the month, the below chart of Seated Diners in the United States shows according to OpenTable that traffic worsened immediately after Q2 Earnings were reported and only got worse throughout the quarter, dipping to its worst levels since April in late September at [-] 8%.

Obviously, not all brands are the same and some with more loyal customers have been able to buck this trend somewhat, with North Italia certainly doing much better than the industry average in Q2. Still, August and September were not only brutal months for casual dining brands but also for quick-service, which had its worst month of the year in September, suggesting some change in behavior among consumers, with the possibility that rising gas prices weighed on already tight wallets from rising utility, grocery and mortgage/rent costs to further dent consumer sentiment. And while the trend lower in casual dining traffic isn't encouraging for Cheesecake Factory, the dip in quick-service is arguably more concerning, given that this was one area that was holding up well, suggesting that we may finally be nearing the point where things are starting to worsen for some consumers.

Fortunately, Cheesecake Factory has managed to grow its margins despite the negative traffic and the company appears confident in this continuing which is helping its annual earnings per share. That said, the company did call out sticky wage inflation that remains in the mid single-digit range, and some of this margin help has come from above-average pricing which has distorted the results a little with 10% pricing in the most recent quarter. So, while Q3 will benefit from additional pricing and margins could hold up, I'm less confident in the company's ability to continue improving margins in 2024 as price starts to roll off and with Cheesecake Factory potentially having to be more careful with taking price if traffic did indeed roll over in Q3 and remain below expectations in Q4 (which is what industry-wide traffic trends imply).

So, with a low probability of beating the revenue midpoint for Q3 ($845 million), and a softer 2024 outlook than I had previously due to what looks to be a slightly negative change relative to Q2 in consumer behavior, I don't see any reason to rush into the stock ahead of earnings. This is especially true given that there's no clear margin of safety in CAKE despite its 50%+ correction from its highs. Let's take a closer look below:

Valuation

Based on ~51.3 million shares and a share price of $29.00, Cheesecake Factory trades at a market cap of ~$1.49 billion and an enterprise value of ~$3.23 billion. This gives it one of the lower capitalizations within the casual dining space, behind names like Bloomin Brands (BLMN), Dave & Buster's (PLAY), and Cracker Barrel (CBRL), but ahead of smaller names like Kura Sushi (KRUS), BJ's Restaurants (BJRI), and Chuy's (CHUY). However, while the stock is down considerably from its highs, peaking at a market cap of ~$3.2 billion in 2021, it's still hard to argue for an adequate margin of safety, especially when adjusting for the difficult macro environment and significantly higher rates. This is because it currently trades at ~12x forward EV/EBITDA and below its average EV/EBITDA multiple of ~15.2 over the past three years, but still above its long-term average of ~11.9x dating back to 2010 and multiples were more favorable during this period due to lower rates and there being no attractive alternative to equities.

Besides this, the current environment for restaurants is among the worst it's been in memory, with above-average wage inflation, sticky commodity inflation, higher build costs for new restaurants, and a much weaker average consumer. Hence, I would argue that the multiples that many restaurants enjoyed from 2010 to 2019 were too high, and some multiple compression would not be surprising. So, using what I believe to be a more conservative multiple of 12.0x EV/EBITDA to derive fair value, FY2024 estimates of ~$282 million and 51 million shares, I see a fair value for the stock of $33.00. And while this fair value estimate points to a 14% upside from current levels, I am looking for a minimum 25% discount to fair value for small-cap names. So, after applying this discount, CAKE's ideal buy zone doesn't come in until $24.80 or lower, suggesting there's still no reason to rush into the stock.

Obviously, I could be wrong and the market may wake up tomorrow and change its mind regarding where casual dining names should trade. However, with a backdrop of negative traffic, sticky wage inflation and slower-than-planned development for many brands, I think it's best to ensure a significant of safety when starting new positions as there's no clear catalyst for higher prices, especially in a higher for longer interest rate environment. Plus, if one looks out across the market, I think there are better deals elsewhere, with names in other beaten-up sectors with higher growth trading at more attractive multiples. One example is Aritzia (ATZ:CA) which trades at just ~7.8x EV/EBITDA (CAKE: ~12.0x EV/EBITDA) with similar unit growth projections. Hence, if I were looking to put new capital to work in the Retail Sector (XRT), this is a name I would prefer to buy on dips.

Summary

Cheesecake Factory had a better quarter in Q2 and certainly made progress from a margin standpoint, with the company noting better-than-expected labor productivity and lower costs across food & beverage, labor, and other operating expenses. That said, the bulk of these gains were driven by above-average menu pricing, and while traffic has outperformed at North Italia (~10% of the system), it has remained negative at Cheesecake Factory and this was before industry-wide traffic rolled over even further in Q3, with a sluggish start to Q4 as well. So, with a low probability of a beat in Q3 given the challenging backdrop and still no margin of safety, I don't see any rush to rush in to catch this falling knife just yet.