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Fool On The Hill

Friday, February 12, 1999

FOOL ON THE HILL
An Investment Opinion
by Warren Gump

A Delicious Stock

Using your own experience is always a terrific way to find stocks. Any investor who has ever tried eating at the Cheesecake Factory (Nasdaq: CAKE) should have wondered whether this company is publicly traded. It is rare when you can go to one of this company's 27 restaurants and have a wait of less than an hour. When living in Atlanta a couple of years ago, the only way I found to avoid a wait was arriving between 10:00 a.m. and 10:30 a.m. on Sunday morning, right after the restaurant opened. Drop in after 11:00 a.m., though, and your wait is almost always an hour or two.

When you find a store and concept you like, many other people will often already know about the product or company. Investigating the stock, you find that it has a high price/earnings multiple, high leverage, or some other characteristic that is unattractive. That generally has been the case with this company, as well. At times, The Cheesecake Factory has been trading for more than 40x prospective earnings. Perhaps that's not too high considering the outstanding prospects for this wonderful chain. Nonetheless, I prefer purchasing the stock when it's a little less expensive, providing a more significant margin of safety.

Because this company is in the restaurant business, which is notoriously fickle and volatile, the stock market provides numerous opportunities to get in at more reasonable prices. Adverse quarterly shifts in same-store sales, bad weather, high food costs, store opening expenses, or short-term operational problems often occur and send short-term investors scurrying for shelter. These stocks regularly rise and fall 15%-25% on the smallest bit of information. I happen to like the volatility associated with restaurant companies because it provides numerous low-priced entry points into long-term winners. And I do think Cheesecake Factory is going to be a force in the restaurant business in the years ahead.

The company's stock has fallen from its December high of $30 3/8 to $20 1/4, recording earnings that were not only below expectations, but also below the prior year. For Q4, the company earned $0.15 per share compared to $0.16 last year. Such numbers certainly are not indicative of a strong growth company.

What happened? Beyond being in the restaurant business, the Cheesecake Factory operates a manufacturing facility that makes over 50 varieties of cheesecakes. This 45,000 square foot facility, which quadrupled production capacity, was opened in 1995 and has been a continual source of problems. The primary issue facing the plant is that the facility has too much capacity for the company's current needs. In early 1998, the plant was only operating at about a third of its ultimate capacity.

Only about 30% of the facility's production is used in the company's restaurants. The majority of production goes to third parties, including warehouse clubs, other restaurant concepts, and foodservice distributors. While restaurant sales have continued to grow rapidly (28% in 1998), bakery sales growth has been more tepid (14% in 1998). Without faster growth of third-party sales, the prospects for this plant quickly reaching efficient operating levels is dim.

To address this issue, the company recently ramped up promotional spending to boost bakery sales. It was successful in this endeavor (Q4 bakery sales were up 40%), but a significant portion of the incremental sales were in lower margin products. In addition, the surge in demand caused significant labor inefficiencies. To top things off (this is starting to sound like a plot for a potential I Love Lucy episode), cream cheese and manufacturing cream also hit record highs during the quarter. The confluence of these three events at the manufacturing facility led to the poor quarterly results.

Many people have suggested that the company sell off the manufacturing plant and just focus on its restaurants. Management, however, doesn't seem inclined to relinquish control over the centerpiece of their restaurant concept. In a way, I can't blame them. The bakery items are a "signature" of the restaurants and could provide significant growth.

If the changes implemented at the manufacturing plant work and the problems get resolved, management could be correct in holding onto the plant. If the problems persist, however, they will need to look at alternatives. Outsourcing has become quite prevalent in consumer goods and may be worth further evaluation. Without manufacturing worries, the company could focus on what it does best... developing and operating restaurants.

Among the 200 largest chains in the nation, The Cheesecake Factory leads them all in terms of revenue per restaurant. Its units averaged $9.8 million in revenue in 1997, up from $9.3 million in 1996. The recipe for success involves operating large stores with over 200 menu items crossing numerous styles of cuisine. To check out the company's offerings, click here for an on-line menu. Despite the wide variety of its offerings, everything I've eaten at the chain has tasted excellent.

Beyond providing quality food, the company also invests heavily in its facilities, spending $375 to $425 per square foot to create what I would describe as a surreal, fantasy-like environment. Importantly, the restaurants are all located in high-traffic areas that fuel high revenues. While the building and structure are an important element of the Cheesecake Factory experience, the food is what keeps people coming back again and again. Planet Hollywood (NYSE: PHL) and Rainforest Cafe (Nasdaq: RAIN) could likely have avoided some of their problems if they remembered this little truism regarding the restaurant business.

The Cheesecake Factory's restaurant performance continues to shine. During Q4, same-store sales jumped an impressive 6.2% on top of a 6.4% jump the prior year. For all of 1998, same-store sales were up 4.0%. This chain has legs. And it plans to continue expanding.

The objective this year is to expand restaurant operating weeks by at least 25%. Two new restaurants are scheduled for opening this month, one in San Diego, the other in Thousand Oaks, CA. Looking at the company's balance sheet, financing future growth should not be a problem. The company has $52 million in cash and no long-term debt. The individualized and intricate nature of each store sometimes causes delays in openings (and the stock price dips temporarily on such news), but that does not impact long-term prospects.

Investors looking for an exciting, growing restaurant chain may want to take a further look at The Cheesecake Factory. First Call consensus estimates call for the company to earn $0.92 per share this year and $1.18 in 2000. The long-term growth rate is forecasted to be 27%. Shareholders in this stock will not have a smooth ride, but they may enjoy the company's success in the years ahead.

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