The Cheesecake Factory Incorporated 2017 Q2 10-Q Summary
Business context and reporting period
The company operates upscale-casual restaurants, bakeries and international licensed locations. As of August 9, 2017, it operated 207 company-owned restaurants, 16 internationally licensed Cheesecake Factory restaurants and two bakery production facilities. The filing covers the 13 weeks and 26 weeks ended July 4, 2017, compared with periods ended June 28, 2016. Fiscal 2017 has 52 weeks, versus 53 weeks in fiscal 2016; management estimated that the prior-year 53rd week increased revenue by approximately $54.7 million and diluted EPS by approximately $0.07.
Financial performance and liquidity
| Metric | Q2 2017 | Q2 2016 | 26 Weeks 2017 | 26 Weeks 2016 |
|---|---|---|---|---|
| Revenue | $569.9 million | $558.9 million | $1,133.3 million | $1,112.6 million |
| Income from operations | $50.2 million | $55.2 million | $93.8 million | $103.8 million |
| Operating margin | 8.8% | 9.9% | 8.3% | 9.3% |
| Net income | $38.2 million | $38.6 million | $73.2 million | $72.5 million |
| Diluted EPS | $0.78 | $0.78 | $1.49 | $1.46 |
| Net margin | 6.7% | 6.9% | 6.5% | 6.5% |
Q2 revenue increased 2.0%, while first-half revenue increased 1.9%, primarily from new restaurant openings and higher third-party bakery sales. Cheesecake Factory comparable sales declined 0.5% in Q2 and 0.1% year to date, as traffic declined 2.4% and 2.3%, respectively, partly offset by average-check growth of 1.9% and 2.2%. External bakery sales increased to $13.1 million in Q2 from $11.8 million and to $25.3 million year to date from $23.1 million.
Profitability weakened as labor costs increased to 33.9% of revenue in Q2 from 33.2%, and other operating costs increased to 24.1% from 23.6%. Cost of sales improved to 22.6% from 22.7%. General and administrative expense declined to 6.2% of revenue from 6.4%. The effective tax rate decreased to 21.5% in Q2 and 19.5% year to date, from 27.2% and 26.9%, respectively, primarily due to the adoption of share-based compensation tax accounting and a higher FICA tip credit.
Cash provided by operating activities was $113.9 million for the first half, down from $158.4 million in the prior-year period. Capital expenditures were $43.7 million, compared with $40.2 million, and the company invested $9.0 million in North Italia and Flower Child. Cash dividends paid were $23.2 million and treasury stock purchases were $30.6 million. Cash increased to $66.3 million from $53.8 million at fiscal year-end.
The company had no borrowings under its $200 million unsecured revolving credit facility and had $177.5 million of net borrowing availability at July 4, 2017, after $22.5 million of standby letters of credit. Net adjusted leverage was 2.4 versus a maximum covenant of 4.0, and the EBITDAR ratio was 3.0 versus a minimum covenant of 1.9. The company was in compliance with its covenants.
Material changes versus the prior comparable period
- Revenue rose modestly, but operating income declined 9.0% in Q2 and 9.6% year to date, reflecting labor inflation, higher utilities and repairs, insurance costs, depreciation and sales deleverage.
- Comparable restaurant traffic remained negative, despite menu pricing and higher average checks.
- Q2 impairment and lease-termination expense was $0.4 million, versus none in the prior-year quarter; first-half expense was $1.2 million.
- Preopening costs declined to $1.3 million in Q2 and $2.3 million year to date, from $2.3 million and $4.6 million, respectively, because the company relocated one restaurant rather than opening new restaurants during the comparable periods.
- Share repurchases declined to $30.6 million year to date from $76.6 million, while dividends increased to $23.2 million from $19.6 million.
- The company adopted share-based compensation tax guidance prospectively. The adoption reduced Q2 income tax expense by $1.6 million and first-half income tax expense by $5.5 million.
Guidance, outlook, risks and unusual items
Management expected third-quarter diluted EPS of $0.60 to $0.64, based on a 1% to 2% comparable-sales decline at Cheesecake Factory restaurants. Fiscal 2017 adjusted diluted EPS guidance was $2.62 to $2.70, based on approximately a 1% comparable-sales decline, food-cost inflation of 1% to 2%, wage-rate inflation of approximately 5%, an operating margin of approximately 7.5% and a corporate tax rate of approximately 22%.
The company planned to open as many as eight company-owned restaurants, including one relocated Cheesecake Factory restaurant and a second RockSugar Southeast Asian Kitchen location, and as many as four international licensed restaurants. Fiscal 2017 capital expenditures were expected to be $125 million to $135 million, excluding $12.6 million of expected non-capitalizable preopening costs. Management expected substantially all free cash flow plus employee stock-option proceeds to fund dividends and share repurchases.
Key risks include negative customer traffic, wage and commodity inflation, insurance and utility costs, competition, macroeconomic conditions, execution of new restaurant development, international expansion and licensee performance. A hypothetical 1% increase in food costs would have reduced Q2 cost of sales by approximately $1.3 million and first-half results by approximately $2.6 million.
Pending matters include wage-and-hour and other employment lawsuits, gratuity-calculation litigation, credit-card information lawsuits and an IRS examination concerning $12.9 million of disallowed domestic production activity deductions for tax years 2010 through 2012. The company stated that potential liabilities generally could not be reasonably estimated and therefore were not reserved, except for an immaterial reserve related to an approved wage-statement settlement. Management stated that pending matters were not expected to have a material adverse effect, individually or in aggregate, although future periods could be affected.
The company recorded $0.4 million of Q2 and $1.2 million of year-to-date accelerated depreciation and impairment expense related to one restaurant relocation and one lease expiration. Adjusted diluted EPS was $0.78 in Q2 and $1.51 year to date, compared with GAAP diluted EPS of $0.78 and $1.49.
Important facts for investors to verify
- Whether comparable-sales declines and negative traffic persist and affect the fiscal 2017 EPS outlook.
- Whether wage, food, insurance, utility and occupancy inflation causes further margin deterioration.
- Actual restaurant openings, capital spending and preopening costs versus the stated plans.
- Operating cash flow conversion and the ability to fund dividends, buybacks and growth investments without drawing on the revolver.
- Progress and eventual funding requirements for North Italia and Flower Child, including potential acquisition obligations in two to four years.
- Developments in employment, gratuity, credit-card and tax proceedings, for which the filing does not provide a clear maximum exposure.
- The effect of the fiscal 2016 53rd week when assessing year-over-year trends.
- The future impact of required lease accounting adoption in fiscal 2019, which management expects to materially affect the financial statements.