False Assumptions Can Be Disastrous
William is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
I like to travel and when I leave my home state of West Virginia I like to see wonders that I don’t get to see at home. When I travel I also like to see businesses that are talked about in the financial press but aren’t located in West Virginia. Recently I took a trip to Colorado and saw the much talked about Whole Foods, Chipotle Mexican Grill, and Costco. We didn’t have time to go in the aforementioned businesses but I did make it into another restaurant that isn’t located in West Virginia known as The Cheesecake Factory (NASDAQ: CAKE). The experience in that restaurant reminded me of the importance of providing a relaxing, positive atmosphere with lots of exciting and different choices as part of having a successful business. This experience also reminded me that false assumptions can be disastrous as well as leading to missed opportunities when it comes to investing.
Before I ever set foot in a Cheesecake Factory I always thought it was a chain of little delicatessens with nothing but cheesecakes. When my wife and I walked through the front door the first thing I saw were the elaborate displays of cheesecakes and cakes in general. This gave me the impression that this restaurant can do other types of food just as well.
When the more than enthusiastic waitress sat us down I was impressed by the menu that “read like a novel” with so many pages to it. The choices of food and beverages were enormous. In addition to the multitudes of cheesecakes, cakes and other desserts they had Italian foods, steaks, and seafood.
The restaurant had a themed look on the inside and the employees made sure you were taken care of. This provided a relaxed feel of being in a luxurious environment. As an investor I like companies that try to pamper and take care of their customers.
After visiting this Cheesecake Factory I decided to research their annual reports and SEC filings to see if the company would be a worthy investment. I discovered that there was growth in revenue and earnings, but the cash situation is not as good as I would like for a company that would go into my portfolio.
Cheesecakes’ revenue and operating cash flow growth was 16% and 22% respectively between 2007 and 2011 (see chart below). Total debt to equity ratio was at 81% as of the most recent quarter which is below my personal threshold of 85%. Revenue has grown 5%, year to date, for FY 2012; however, operating cash flow is down 21% year to date. Free cash flow has been on the decline over the last three years and is down 39% so far this year. This is due to the opening of new stores.
The metric that really bothers me is that the cash to stockholder’s equity has declined steadily from 18% in 2008 to the current 9% in the most recent quarter. Stock buybacks are excessive. In 2011 stock buybacks as a percentage of free cash flow was 145%. Year to date stock buybacks to free cash flow is at 149%. A company whose cash as a percentage of stockholder’s equity is declining is a concern for me.
Other restaurants like to provide their customers with themed ambience to improve the experience. In Bob Evans (NASDAQ: BOBE) they provide a sit down family atmosphere. This induces people to bring their families along. Pictures of the original farm instill a sense of American nostalgia. Cracker Barrel (NASDAQ: CBRL) gives you a feeling of nostalgia as well. It has pictures of old magazines and soda advertisements. You also can find beverages and candies in their stores that you can’t find anywhere else. Cracker Barrel’s menu doesn’t have as many choices as the Cheesecake Factory but their portions are huge and they come at a relatively low price which provides great value.
Nostalgia doesn't necessarily equate to more revenue. Bob Evans' revenue has been in a state of decline for the past five years (see chart below). Their revenue has declined 3% during that time. Cracker Barrel's revenue has increased a mere 2% during that time.
Cracker Barrel is faring better from a cash flow stand point (see chart below). Its cash flow has grown about 229% according to the chart. Bob Evans operating cash flow has fallen 8%.
Before I went into the Cheesecake Factory I had the false assumption that the restaurant was about cheesecakes only. After I went into the restaurant I was pleasantly surprised. I also had the false assumption that this company’s fundamentals would be out of this world. While there is growth in revenue, earnings, and even operating cash flow, the decline in free cash flow and cash to stockholder’s equity due to stock buybacks give me reason for concern and I will not be adding this company to my portfolio any time soon. I am going to have to pass on Bob Evans and Cracker Barrel for now as well. Don’t take my word for it. Do your own research and draw your own conclusion; that is the Foolish way.
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