The Cheesecake Factory’s 33.6% return over the past six months has outpaced the S&P 500 by 20.2%, and its stock price has climbed to $50.49 per share. This was partly due to its solid quarterly results, and the run-up might have investors contemplating their next move.

Despite the momentum, we're cautious about The Cheesecake Factory. Here are three reasons why you should be careful with CAKE and a stock we'd rather own.

Why Is The Cheesecake Factory Not Exciting?

Celebrated for its delicious (and free) brown bread, gigantic portions, and delectable desserts, Cheesecake Factory (NASDAQ: CAKE) is an iconic American restaurant chain that also owns and operates a portfolio of separate restaurant brands.

1. Weak Operating Margin Could Cause Trouble

Operating margin is an important measure of profitability for restaurants as it accounts for all expenses keeping the lights on, including wages, rent, advertising, and other administrative costs.

The Cheesecake Factory was profitable over the last two years but held back by its large cost base. Its average operating margin of 3.2% was weak for a restaurant business. This result is surprising given its high gross margin as a starting point.

2. Previous Growth Initiatives Haven’t Paid Off Yet

Growth gives us insight into a company’s long-term potential, but how capital-efficient was that growth? Enter ROIC, a metric showing how much operating profit a company generates relative to the money it has raised (debt and equity).

The Cheesecake Factory historically did a mediocre job investing in profitable growth initiatives. Its five-year average ROIC was 1.2%, lower than the typical cost of capital (how much it costs to raise money) for restaurant companies.

3. High Debt Levels Increase Risk

As long-term investors, the risk we care about most is the permanent loss of capital, which can happen when a company goes bankrupt or raises money from a disadvantaged position. This is separate from short-term stock price volatility, something we are much less bothered by.

The Cheesecake Factory’s $1.88 billion of debt exceeds the $52.22 million of cash on its balance sheet. Furthermore, its 7× net-debt-to-EBITDA ratio (based on its EBITDA of $276.2 million over the last 12 months) shows the company is overleveraged.

At this level of debt, incremental borrowing becomes increasingly expensive and credit agencies could downgrade the company’s rating if profitability falls. The Cheesecake Factory could also be backed into a corner if the market turns unexpectedly – a situation we seek to avoid as investors in high-quality companies.

We hope The Cheesecake Factory can improve its balance sheet and remain cautious until it increases its profitability or pays down its debt.

Final Judgment

The Cheesecake Factory isn’t a terrible business, but it doesn’t pass our quality test. With its shares beating the market recently, the stock trades at 14.6× forward price-to-earnings (or $50.49 per share). While this valuation is reasonable, we don’t really see a big opportunity at the moment. We're fairly confident there are better stocks to buy right now. We’d recommend looking at KLA Corporation, a picks and shovels play for semiconductor manufacturing.

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