Can You Have Your Cake and Profit Too?

Dan is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

The short position on The Cheesecake Factory (NASDAQ: CAKE) continues to increase and it now stands at 13.30% of float. This lofty number might not make sense to the average investor considering the company’s margins are good and revenue is growing. And those aren’t the only positives. Management is also obsessed with finding ways to cut costs, which is a good sign as it leads to improved earnings. So who's going to be right -- the shorts or the longs?

Cutting costs

In the current economic environment, it’s important to invest in companies that are dedicated to cutting costs. This is simply because revenue growth is difficult to come by, which ties into the health of the consumer. If a company is capable of successfully cutting costs, then margins will improve and that company is more likely to meet or beat expectations. For instance, The Cheesecake Factory beat expectations last quarter.

Management looks to cut costs wherever possible. To reduce energy costs, it uses low-wattage light bulbs to limit kilowatt usage by 2% to 3% per year (based on 10,000-square-foot restaurant). It also uses energy-efficient HVAC models and it's currently testing a new demand ventilation system that automatically adjusts based on internal environmental conditions. Furthermore, The Cheesecake Factory is testing a solar thermal system as a renewable energy source to heat water at one of its restaurants.

It’s important to understand that these are only a few examples of how The Cheesecake Factory aims to cut costs. As long as management remains focused, the list will continue to grow. This is a big positive for investors.

All that said, it might not matter. Oil prices are now spiking, which will slow the consumer; many people are taking lower-wage jobs for lack of better options; and increased payroll taxes will eventually be felt.

The Cheesecake Factory vs. peers

The Cheesecake Factory has increased revenue for three consecutive years and it managed to deliver profits during the difficult years of 2008 and 2009. However, the stock didn’t perform well as investors anticipated future declines.

The Cheesecake Factory has a market cap of $2.25 billion and it’s looking to increase its size by expanding abroad. Licensing agreements are in place for 22 restaurants to open in five countries in the Middle East as well as 12 restaurants in Latin America. Further expansions are possible in both areas. The Cheesecake Factory owns a profit margin of 5.61%, and its dividend is around 1%.

Brinker International (NYSE: EAT) is similar in size, with a market cap of $2.85 billion, and it owns Chili’s as well as Maggiano’s Little Italy. Foot traffic has increased, management kept costs under control, and cost inflation has been reduced. On the other hand, with only two brands to rely on, Brinker International is sensitive to consumer trend changes. The same can be said for The Cheesecake Factory, which owns its namesake brand, Grand Lux Café, and RockSugar Pan Asian Kitchen. However, The Cheesecake Factory relies mostly on its namesake brand (Brinker relies mostly on Chili’s).

Brinker owns a profit margin of 5.77%, which is solid for the industry and demonstrates good management. Brinker yields 1.90%, but with a debt-to-equity ratio of 2.87, it’s not likely that the company will increase capital returns to shareholders in the future. And even if it does, it’s not likely to be sustainable.

One company that doesn’t have to rely heavily on one specific brand is Darden Restaurants (NYSE: DRI). Darden is a much larger company, with a market cap of $6.50 billion. It owns several brands, the most popular being Red Lobster, Olive Garden, and LongHorn.

Darden has grown revenue over the past three years and generally earns healthy profits. Its profit margin is 4.82% and it yields an impressive 4.40%. However, with a debt-to-equity ratio of 1.32, it’s not likely for the company to substantially increase capital returns to shareholders. This debt also has the potential to impede growth potential.

On the other hand, Darden is looking to boost its top-line growth by expanding internationally. Its inked several recent deals so its exposure in Latin America should significantly grow, which should be a positive considering the regions increase in middle-income consumers. Apparently the demand for Americanized restaurants is high throughout most of Latin America. 

Conclusion

The Cheesecake Factory is well-managed, the food is widely thought to be of good quality, the atmosphere of its restaurants continues to be a big draw, and international growth leads to future growth potential. On the other hand, it isn’t a resilient stock, which was proven during the financial crisis, when the stock took a 50% hit.

Ultimately, those that are long might be right. But regardless of how well-managed a company is, it all comes down to the consumer. With rising oil prices, lower wages, and increased taxes, it’s only a matter of time before restaurant spend slows. When that happens, even the most diversified chain will feel the cash crunch.

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Dan Moskowitz has no position in any stocks mentioned. The Motley Fool owns shares of Darden Restaurants. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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