Business Context and Reporting Period
The Cheesecake Factory Incorporated filed an unaudited Form 10-Q for the thirteen and thirty-nine weeks ended October 1, 2019. Fiscal 2019 is a 52-week year ending December 31, 2019. The company operated 290 company-owned restaurants in the United States and Canada, 23 internationally licensed Cheesecake Factory locations, and two bakery facilities.
The company adopted ASC 842 lease accounting on January 2, 2019, recognizing substantial operating lease assets and liabilities and reducing beginning retained earnings by $41.5 million, net of tax.
Financial Performance and Key Metrics
| Metric | Q3 2019 | Q3 2018 | 39 Weeks 2019 | 39 Weeks 2018 |
|---|---|---|---|---|
| Revenue | $586.5 million | $575.2 million | $1,788.7 million | $1,747.2 million |
| Income from operations | $27.0 million | $33.5 million | $97.2 million | $99.6 million |
| Operating margin | 4.6% | 5.8% | 5.4% | 5.7% |
| Net income | $16.1 million | $28.5 million | $78.6 million | $82.9 million |
| Net margin | 2.7% | 5.0% | 4.4% | 4.7% |
| Diluted EPS | $0.36 | $0.61 | $1.76 | $1.79 |
| Operating cash flow | Not provided for quarter | Not provided for quarter | $116.2 million | $182.1 million |
Q3 revenue increased 2.0%; revenue for the first 39 weeks increased 2.4%. The Cheesecake Factory restaurant comparable sales increased 0.4% in Q3 and 0.9% for the first 39 weeks, while customer traffic declined 3.7% and 3.0%, respectively. Average check increased 4.1% in Q3 and 3.9% year to date, driven primarily by pricing and favorable mix.
- Q3 cost of sales improved to 22.7% of revenue from 23.0%, while year-to-date cost of sales improved to 22.6% from 22.8%.
- Labor expense increased to 36.4% of revenue in Q3 and 36.3% year to date, primarily due to higher wage rates; Q3 also reflected higher stock-based compensation and payroll taxes.
- Other operating costs increased to 25.5% of revenue in Q3 and 25.2% year to date, primarily from lease accounting effects and higher marketing expense.
- Q3 included a $10.3 million loss on unconsolidated affiliates, compared with $1.6 million in the prior-year quarter. The year-to-date loss was $13.4 million versus $2.7 million.
- Q3 G&A included $3.2 million of acquisition-related costs. No asset impairment or lease termination costs were recorded in 2019, compared with $0.3 million in Q3 2018 and $2.8 million year to date in 2018.
- Adjusted diluted EPS was $0.59 in Q3 and $2.04 for the first 39 weeks, compared with $0.64 and $1.87, respectively. These non-GAAP measures exclude affiliate losses, acquisition costs and, for 2018, lease termination costs.
Liquidity, Debt, Capital Allocation, and Balance Sheet
- Cash and cash equivalents were $306.3 million at October 1, 2019, versus $26.6 million at January 1, 2019.
- Operating cash flow was $116.2 million, down from $182.1 million, primarily due to the timing of tax payments, prepaid expenses, inventory changes and other working-capital items.
- Capital expenditures were $46.7 million, compared with $78.7 million in the prior-year period. Investments and loans to unconsolidated affiliates totaled $25.5 million.
- The company entered into a $400 million unsecured revolving credit facility maturing July 30, 2024. At October 1, $335.0 million was outstanding and $19.4 million was committed to standby letters of credit, leaving $45.6 million of net availability.
- The company reported a Net Adjusted Leverage Ratio of 3.3 and an EBITDAR Ratio of 2.5, versus covenant limits of 4.75 maximum and 1.9 minimum, respectively, and was in compliance with its covenants.
- Operating lease liabilities totaled approximately $1.05 billion on a present-value basis. Future undiscounted operating lease payments totaled $1.64 billion.
- The company paid $45.0 million in dividends and repurchased $50.6 million of common stock during the first 39 weeks. Cumulative repurchases totaled 52.9 million shares for $1.69 billion.
Material Changes, Acquisitions, and Outlook
On October 2, 2019, immediately after the reporting period, the company completed acquisitions of North Italia and Fox Restaurant Concepts, including Flower Child and other FRC brands. The acquired businesses operated 21 North Italia locations and 47 FRC locations at closing.
- Consideration included $286 million of cash, primarily funded through the new credit facility; assumed debt of $10 million; $45 million of deferred consideration; $12 million of indemnity escrow payments; and contingent consideration and the fair value of previously held interests.
- The company expects the acquisitions to accelerate and diversify revenue growth, but purchase accounting and pro forma financial information were not available for this filing and are expected in the fiscal 2019 Form 10-K.
- Fiscal 2019 adjusted diluted EPS guidance, excluding affiliate losses and acquisition impacts, was $2.65 to $2.70, based on approximately 1% comparable sales growth. Q4 guidance was $0.61 to $0.66 based on comparable sales growth of 0.5% to 1.5%.
- Fiscal 2019 assumptions included approximately 2% commodity inflation, 6% wage inflation and a 9% effective tax rate. Capital expenditures were estimated at $80 million to $90 million, plus $10 million for North Italia and FRC openings.
- Fiscal 2020 capital expenditures were expected to be $130 million to $140 million, with up to 20 new restaurants and approximately 7% unit growth. The company also expected an $11.3 million acquisition installment payment.
Management Commentary and Risks
Management emphasized menu innovation, hospitality, off-premise dining, delivery, throughput, gift cards and disciplined new restaurant development. It targets approximately 2% to 3% annual menu price increases and restaurant-level cash-on-cash returns of approximately 20% to 25% for Cheesecake Factory, over 30% for North Italia and 25% to 30% for FRC concepts.
- Key operating risks include wage inflation, commodity volatility, occupancy costs, insurance, marketing expense, customer traffic declines and the ability to maintain margins.
- The acquisitions create integration, execution, contingent consideration and additional financing risks. The company must provide financing to FRC to support specified targets during the five years after closing.
- Legal matters include a potential California wage-and-hour settlement with an immaterial reserve, a $4.2 million California wage citation for which no reserve was recorded, and an $8.0 million IRS tax deficiency dispute for which no reserve was recorded. Management stated that reasonably possible losses from pending matters were not expected to be material, although outcomes remain uncertain.
- A hypothetical 1% increase in food costs would have reduced Q3 cost of sales by approximately $1.3 million. A hypothetical 1% increase in interest rates would have increased annual interest expense by approximately $3.4 million based on October 1 debt.
- Management stated that cash, operating cash flow, available borrowings and landlord contributions should be sufficient for the next 12 months, but distributions and share repurchases are subject to credit-facility covenants.
Investor Verification Checklist
- Verify the final purchase accounting, goodwill, acquired liabilities, pro forma results and contingent consideration for North Italia and FRC in the fiscal 2019 Form 10-K.
- Monitor post-acquisition revenue growth, unit openings, integration costs and compliance with the credit-facility leverage and EBITDAR covenants.
- Reconcile reported operating margin and net income trends after adjusting for ASC 842 lease accounting, affiliate losses and acquisition costs.
- Assess whether comparable-sales growth can offset declining traffic, higher wages, commodity inflation and lease-related occupancy costs.
- Track cash generation, debt repayment, capital expenditures, dividends and share repurchases given limited net borrowing availability at October 1, 2019.
- Review developments in the California wage citation, wage-and-hour litigation and IRS tax dispute.