Financial Evaluation of The Cheesecake Factory Inc.

Transcription

1 Financial Evaluation of The Cheesecake Factory Inc. Joey Farquhar Tim Hipsher Trevor Rathbun Benjamin Johnson Charlie Horan 1 P a g e

2 TABLE OF CONTENTS EXECUTIVE SUMMARY 6 INDUSTRY ANALYSIS 7 ACCOUNTING ANALYSIS 9 FINANCIAL ANALYSIS 10 VALUATION ANALYSIS 14 COMPANY/INDUSTRY OVERVIEW 15 COMPANY OVERVIEW 15 INDUSTRY OVERVIEW 15 FIVE FORCES ANALYSIS 18 RIVALRY AMONG EXISTING FIRMS 19 THREAT OF NEW ENTRANTS 31 THREAT OF SUBSTITUTION 32 BARGAINING POWER OF SUPPLIERS 32 BARGAINING POWER OF CUSTOMERS 33 KEY SUCCESS FACTOR ANALYSIS 34 COST LEADERSHIP 35 ECONOMIES OF SCALE 35 COST CONTROL 36 DIFFERENTIATION 36 SUPERIOR PRODUCT QUALITY 37 SUPERIOR CUSTOMER SERVICE 37 BRAND IMAGE 38 FIRM COMPETITIVE ADVANTAGE ANALYSIS 39 2 P a g e

3 ACCOUNTING ANALYSIS 42 KEY ACCOUNTING POLICIES 44 TYPE I ACCOUNTING POLICIES 44 ECONOMIES OF SCALE 44 CUSTOMER SERVICE 46 PRODUCT QUALITY 47 TYPE II ACCOUNTING POLICIES 48 OPERATING LEASES 48 CONCLUSION 49 DEGREE OF ACCOUNTING FLEXIBILITY 50 OPERATING LEASES 50 GOODWILL 51 CONCLUSION 52 EVALUATION OF ACCOUNTING STRATEGY 52 OPERATING LEASES 53 GOODWILL 55 RESEARCH AND DEVELOPMENT 55 CONCLUSION 55 QUALITATIVE ANALYSIS 56 PRODUCT AND SERVICE QUALITY 57 OPERATING LEASES 58 RED FLAGS 58 ACCOUNTING DISTORTIONS 60 RESTATEMENT TABLE 61 DEPRECIATION TABLE 68 3 P a g e

4 FINANCIAL ANALYSIS 69 LIQUIDITY RATIOS 69 CURRENT RATIO 70 QUICK RATIO 71 INVENTORY TURNOVER 72 INVENTORY DAYS OUTSTANDING 74 ACCOUNTS RECEIVABLE TURNOVER 76 ACCOUNTS REEIVABLE DAYS OUTSTANDING 77 CASH TO CASH 78 WORKING CAPITAL TURNOVER 80 CONCLUSION 81 PROFITABILITY RATIOS 82 SALES GROWTH 82 GROSS PROFIT MARGIN 83 OPERATING PROFIT MARGIN 85 NET PROFIT MARGIN 86 ASSET TURNOVER 88 RETURN ON ASSETS 89 RETURN ON EQUITY 90 CONCLUSION 92 CAPITAL STRUCTURE RATIOS 92 DEBT TO EQUITY RATIO 93 TIMES INTEREST EARNED RATIO 94 ALTMAN S Z-SCORE 96 FINANCIAL FORECASTING 98 INCOME STATEMENT 98 DIVIDENDS FORECASTED 103 BALANCE SHEET 105 STATEMENT OF CASH FLOWS P a g e

5 RESTATED FINANCIALS 114 COST OF CAPITAL ESTIMATION 114 COST OF DEBT 115 COST OF EQUITY 117 BACKDOOR COST OF EQUITY 120 WEIGHTED AVERAGE COST OF CAPITAL 122 COMPARATIVE EVALUATION 125 INTRINSIC VALUATION 129 APPENDIX P a g e

6 Executive Summary Analyst Recommendation: Sell (Overvalued) CAKE 6/1/2014- $45.87 Altman Z-Score 52 Week Range Revenue 1.9 Billion As stated Market Cap 2.25 Billion Restated Shares Outstanding 48.3 Million Market Valuations Price As Stated Restated Trailing P/E Return on Equity Forward P/E Return on Assets P/B PEG Cost of Capital P/EBITDA Estimated adj. r^2 Beta size adj. Ke EV/EBITDA month Intrinsic Valuations 1 year Price 2 year As Stated Re Stated 7 year Discounted Dividend year Discounted Cash Flow Residual Income As stated Restated Long Run ROE Risidual Income Backdoor Ke 10.81% 9.01% BT WACC 11.59% 11.00% Beta P a g e

7 Industry Analysis The Cheesecake Factory is in the full service upscale-casual restaurant industry. The Cheesecake Factory focuses on satisfying customers by delivering quality meals from an innovative menu, and providing superior customer service. Firms in this industry must possess value added business strategies to obtain a competitive advantage over their competitors. When analyzing the industry for it s value added business strategies, we used the Porters Five Forces Model. This can break the competitive forces down by stating the level of competition from the rivalry among existing firms, threat of new entrants, threat of substitute products, bargaining power of customers, and bargaining power of suppliers. This tells us specifics about each firm within the industry as well as data on the overall industry. It s also important because it gives potential investors and current shareholders an idea on how firms are 7 P a g e

8 increasing shareholder wealth. Below is the summary table of Porters Five Forces model for the upscale-casual restaurant industry. Cheesecake Factory's Competitive Forces Rivalry Among Existing Firms: Threat of New Entrants: Threat of Substitute Products: Bargaining Power of Customers: Bargaining Power of Suppliers Level of Competition High Low High High Low Based on the five forces summary, we observed that rivalry among existing firms is high. This high competition is likely caused from low concentration in the industry, economies of scale, and a tight cost control system. The threat of new entrants is low that is mostly due to high switching cost and the need for high levels of economies of scale. The threat of substitute products is high. Customers in this industry have many substitutable products. There is the option of quick service as well as other available restaurants within the industry. Our borrowing power from customers is high and suppliers is opposite. Customers have bargaining power over firms, again, because of the high threat of substitute products. The power of suppliers is low primarily due to the high volume of suppliers. This allows firms to hedge prices and maintain bargaining power over the suppliers. After performing the five forces analysis, we now have a better understanding of the upscale-casual restaurant industry. We were shown how firms gain competitive advantages from a combination of cost control and product differentiation business activities. These activities add value to the firm and ultimately increase shareholder s wealth. 8 P a g e

9 Accounting Analysis During the valuation process of Cheesecake Factory, it is important for us to analyze the accounting policies and procedures presented within the recent 10-K. Companies have the ability to provide or distort certain information within their annual and quarterly reports. It is our responsibility to seek out these distortions and evaluate the quality of information given to us. Often, firms with low quality of disclosure provide minimal details relating to their revenues, expenses, and liabilities and vice versa for firms with high quality disclosure. GAAP does require certain information to be placed in a company s annual report, but it is up to the management s discretion to go beyond the requirement and inform the reader more about their company. To begin the accounting analysis, we determine what Cheesecake Factory s Type 1 and Type 2 key accounting policies. Type 1 accounting policies can be linked to key success factors identified for Cheesecake Factory. We have identified Cheesecake Factory s type 1 accounting policies to be economies of scale, superior customer service, and superior product quality. In Cheesecake s 10-K they go in great detail about their key accounting policies but the remainder of the annual report fails to be at the same level of disclosure as the competition in the industry. Type 2 accounting policies have more potential to distort information provided to readers. We found that Cheesecake Factory s type 2 policies to be capital vs. operating leases and disclosure. Information regarding type 2 accounting policies clearly distorts Cheesecake Factory s financial statements. For example, the firm chooses to use only operating leases allowing Cheesecake to leave a large portion of liabilities placed off the books. By capitalizing the leases we are able to depict a more accurate picture of Cheesecake Factory s liabilities and obligations. 9 P a g e

10 Percentage of Leases by Type 2013 Operating Lease Capital Lease The Cheesecake Factory % 0.00% BJ's Restaurants Inc % 0.00% Brinker Intl % 12.99% Darden Inc % 7.14% The quality of disclosure in Cheese Factory s 10-K is poor. We determined this analysis based on the amount of information presented in the report. Unlike the competitors in the industry, Cheesecake Factory s is below the industry standard providing hardly any information relating to revenues, expenses, and liabilities. The quality of disclosure present raises concerns in our valuation of the company. We will have to identify all the red flags within the 10-K and possibly restate the financial information to give us a more accurate description on the operations of Cheesecake Factory. Financial Analysis The next thing we needed to look at to value The Cheesecake Factory was to analyze the company s financials through ratio analysis, forecasting financials, and performing a regression study to determine cost of equity and backdoor cost of equity. The first thing we had to do was perform a ratio analysis of The Cheesecake Factory. The initial set of ratios we analyzed were the liquidity ratios which include, current ratio, quick ratio, inventory turnover and days outstanding, accounts receivable turnover and days outstanding, cash to cash ratio, and working capital turnover. We analyzed these ratios to determine health of the company and then compared the ratios to the industry. 10 P a g e

11 Ratio Performance Comparison to Trend industry Current Ratio Underperforming Over performing Downward Quick Ratio Underperforming Over performing Downward Inventory Over performing Average Downward Turnover Inventory Over performing Average Upward Days Accounts Over performing Over performing Upward Receivable Turnover Accounts Over performing Over performing Upward Receivable Days Cash to Cash Average Average Stable Working Underperforming Underperforming Upward Capital Turnover Overall Underperforming Over performing Upward The liquidity ratios show how easily a company can pay off their debt with short term assets. After analyzing the liquidity ratios we saw that The Cheesecake Factory underperforms overall but compared to the industry The Cheesecake Factory generally outperforms the industry. We analyzed the profitability ratios next. The profitability ratios tell us how well a company retains income from sales as expenses are being taken out. These ratios include sales growth ratio, gross profit margin, operating margin, net profit margin, asset turnover, ROA, and ROE. We analyzed these ratios to 11 P a g e

12 determine the health of The Cheesecake Factory and then compared the company to the industry. Ratios Performance Compare to Trend Industry Sales growth Average Average Stable Gross profit Average Average Stable margin Operating margin Underperforming Average Stable Net profit margin Underperforming Average Stable Asset turnover Over performing Over performing Upward ROA Underperforming Average Upward ROE Over performing Average Upward Overall average Average stable After analyzing the profitability ratios we determined that The Cheesecake Factory has generally healthy ratios and stay on par with the industry. The last set of ratios we analyzed is the Capital Structure Ratios. These ratios show us how a company funds itself and if it is headed for bankruptcy or not. The capital structure ratios are debt to equity, times interest earned, and Altman s Z score. Again, we looked at these ratios to determine the health of The Cheesecake Factory and then we compared to the industry. Ratio Performance Industry compare Trend Debt to equity Underperforming Underperforming Downward Times interest Underperforming Underperforming Downward earned Z score Over performing Over Performing Upward overall Underperforming Underperforming Downward 12 P a g e

13 After analysis of the capital structure ratios we determined that The Cheesecake Factory has generally unhealthy ratios and are underperforming in the industry. However, the Altman s Z-Score which determines whether or not a company is headed for bankruptcy was very high for The Cheesecake Factory and tells us that the company is in no danger of going bankrupt. The next step we took was to forecast the financials for the company over the next 10 years. Forecasts are very volatile and prone to error but we completed the forecasts as accurately as possible. When forecasting, our main priority is to get a proper equity forecast, therefore, we do not care about the liability forecast. The statement of cash flows is more volatile than the rest of the forecast and is much more prone to error. The main focus of forecasting the statement of cash flows is to get an accurate measurement on dividends so we can get an accurate retained earnings forecast, and to get an accurate CAPEX forecast. The rest of the statement is too prone to error and as such we did not focus on it. The final step in analyzing the financials is to run a regression test to determine cost of capital. After running regressions with a 95% confidence interval we decided on using the beta obtained through the 7 year treasury with a 72 month horizon and got an adjusted beta of 1.637%. With this beta we obtained a cost of equity of 17.46% which includes a size premium of 1.8%. From there we used obtained an as stated backdoor cost of equity of 10.81% and a restated backdoor cost of equity of 9.01% since we had to capitalize the operating leases. We used these backdoor cost of equity rates to obtain an as stated before tax weighted average cost of capital of 17.31% and a restated before tax weighted average cost of capital of 15.69%. 13 P a g e

14 Valuation Analysis After the three prior analyses, we can now value Cheesecake Factory as overvalued, undervalued, or fair. To begin the valuation process, we have established ourselves as 10% analysts. Our results will be based on the benchmark of the current price of $45.87 as of June 1 st, Through this comparison, we will come with a decision on the value of the company. There are two methods for valuation. The first is the method of comparable which uses industry prices as compared the company we are valuing. The second method for valuation is the intrinsic valuation method. The method for the valuation analysis we chose is the intrinsic valuation method. The data for this method is purely based off Cheesecake Factory s values rather than the industries. The intrinsic valuation method consists of four valuation models based off forecasted data; discounted dividends model, free cash flow model, residual income, and long run residual income model. The intrinsic method provides a more accurate and descriptive interpretation on the future of the firm compared to other methods. To find results from these models we take the forecasted data and put them into a series of sensitivity analyses. The results from each model consistently interprets that Cheesecake Factory is overvalued both as a stated and restated basis. The residual income model is our best indicator of our recommendation because of its dependency on the current situation of Cheesecake Factory. Through these series of sensitive analyses, Cheesecake Factory s model values fail to fall within the lower and upper bounds limits of our 10% analysis. We conclude that through our intrinsic valuation that Cheesecake Factory is currently overvalued. 14 P a g e

15 Company Overview The Cheesecake Factory, Inc. is an upscale casual, full service dining establishment that competes in the food service industry and was incorporated in Delaware in The company owns and operates 169 Cheesecake Factory restaurants, 11 Grand Lux Café restaurants, and 1 RockSugar Pan Asian Kitchen restaurant (Cheesecake 10-K). The Cheesecake Factory, Inc. also fully owns and operates 2 bakery production facilities that are utilized to provide the desserts the company is famous for to the restaurants and sell any excess capacity to outside customers (Cheesecake 10-K). The company utilizes a diversified menu to attract guests and fill the restaurant at all hours of operation so they can stay competitive with the rival companies. The great majority of Cheesecake Factories and Grand Lux Cafés are located in the metropolitan areas of large cities or along the edge of metropolitan areas where there are extremely high volumes of traffic per day at all times of day from morning to late evening. The strategic advantage being that the larger the volume of people moving past the restaurant during the day the more opportunity there is for someone to stop in for a meal so that they can maintain a full restaurant at all times of day. Industry Overview The Cheesecake Factory Inc. is a competitor in the restaurant industry in the domestic United States as well as a future competitor in international economies due to current licensing agreements. According to the National Restaurant Association, restaurant sales constitute 4 percent of the U.S. GDP with economic impact of an estimated $1.8 trillion. In billions of current dollars restaurant industry sales have increased from $42.8 billion in 1970 to a projected 15 P a g e

16 $683.4 billion in In 2010, during the middle of the recent economic recession in the United States, restaurant sales were $586.7 billion. The projected sales for 2014, which are $96.7 billion more than 2010, show an increase in sales despite economic distress within consumer households in the United States during this period. Within the restaurant industry there are two primary divisions to categorize establishments: quick service and full service restaurants. Differences between these two categories involve service, quality, and time. Quick service establishments involve fast-food and casual dining restaurants with no tableside service. As the name suggests, quick service involves less waiting time on meals 16 P a g e

17 than full service. Although there is a convenience factor for quick service establishments, they also require the customers to self-serve themselves drinks and other sides they may want or need. In contrast, full service establishments employ waitresses and waiters to serve the guests, require guests to sit down for an extended period of time, and also offer high quality food such as a prime steak or a fresh water salmon made after ordering. Companies in the restaurant industry compete on different levels based on the type of establishment the restaurant is. Full service restaurants rely on highmargin items and effective marketing of brand image in order to drive profits. In contrast, quick service restaurants rely on high efficiency and high sales volume in order to drive profits. The demand in the industry is driven by factors that include demographics, consumer tastes, and consumer income. In terms of demographics and consumer income affecting demand in the industry, the lower the consumer income the less disposable income customers have to spend on dining out. Full service restaurants with higher menu prices target consumers with a higher disposable income. Changing consumer tastes are also a driver of demand in the restaurant industry. New flavors and awareness of ingredients affect what product a company produces in order to gain more market share. For analysis purposes we are defining the industry as upscale casual dining. Upscale casual dining refers to full service establishments that compete with a highly diverse menu selection, high quality service, prices that attempt to target all socioeconomic classes, as well as presenting a décor and an ambiance representative of a high quality establishment. The industry includes the following firms: The Cheesecake Factory Inc., Brinker Intl., Darden Inc., and BJ s Restaurants Inc. 17 P a g e

18 Porter s Five Forces Model Porter s Five-Forces model aids financial analysts in answering questions regarding the business strategy development of the company as well as an overall industry analysis. This model also helps prospective and current investors develop a better understanding of the industry in which the company operates as well as the business strategy that the company implements in order to increase shareholder wealth. The model consists of two factors, actual and potential competition to a firm and bargaining power of customers and suppliers. The competition factor of the model has three sub categories which include rivalry amongst existing firms, the threat of new entrants, and the threat of substitute product. These three sub categories along with the bargaining power of customers and suppliers factor lead to industry profitability and help companies decide how to operate the business activities and price products in order to increase profit margins. There are three levels of competition in an industry that the Five-Forces model shows us: high competition, mixed competition, which consists of high and low form of competition components, and low competition. High competition does not allow firms room for variances in standard prices of products in an industry while low competition allows firms to be able to specialize in a few products, allowing control of prices and markets. All of the five aspects of the model work together to help analyze the prospective profitability of an industry as well as the firm in the industry. 18 P a g e

19 Cheesecake Factory's Competitve Forces Rivalry Among Existing Firms: Threat of New Entrants: Threat of Substitute Products: Bargaining Power of Customers: Bargaining Power of Suppliers: Level of competition High Low High High Low Rivalry Among Existing Firms Rivalry among existing firms is a sub category of competition in the Five- Forces model we are using for analysis. This category measures the competition that is present in the upscale casual dining industry. When measuring the level of competition of rivalries among existing firms, key success factors include: Concentration of the industry Product differentiation Growth rate of specific firms and the industry as a whole Scale and learning economies Switching costs Excess capacity Utilizing these factors in the Five-Forces model can help firms improve and maintain an efficient current business strategy in the industry in order to grow profit margins. 19 P a g e

20 % of Share Industry Concentration The amount and size of the firms in an industry define the industry s degree of concentration. The degree of concentration determines whether firms in an industry can be a price-taker or a price-setter. If the industry is dominated by one firm it is considered a monopoly and the dominant firm will be the pricesetter, with less dominant firms using the prices as a benchmark. Industries that have three or four equally sized firms cooperate in order to avoid price competition that can become destructive to the industry as a whole, resulting in a mix between price-setting and price-taking. Industries with fragmentation face steep price competition between the firms involved. The degree of concentration in the upscale casual dining industry in the United States is low due to existing firms expanding their brands year to year. Shown below is the industries concentration based on sales Industry Market Share (Sales) Cheesecake Factory Inc BJ's Restaurants, Inc Darden Inc Brinker Intl Years 20 P a g e

21 The industry market share based on sales indicate that Darden Inc., holds the majority of market share in the industry with Cheesecake Factory, Brinker Intl., and BJ s Restaurants rounding out the bottom 40% of market share. One factor behind the large market share of Darden Inc. is the number of restaurants the company currently has in operation. Darden currently [operates] 2,138 restaurants that include 8 different brands (Darden 10K). Brinker Intl. operates more than 1,600 restaurants with the brands being Chili s and Maggiano s (Brinker 10-K). The Cheesecake Factory Inc. and BJ s Restaurants operate on a smaller scale than both Brinker and Darden. The Cheesecake Factory owns and operates 181 restaurants with 169 under the Cheesecake Factory mark, 11 under the Grand Lux Café, and 1 under the RockSugar Pan Asian Kitchen mark (Cheesecake 10-K). BJ s currently owns and operates 150 restaurants as of May 2014 (BJ s 10-K). Although the firms in the industry vary in size, the average check per person was in the range of $16.25 to $16.75 for Darden Inc. during 2013 (Cornell). The average check per person for The Cheesecake Factory Inc. during fiscal 2013 was approximately $19.70 (Darden 10-K). BJ s Restaurant has an average customer check of $11.00 to $17.00 during 2013 (BJ s 10-K). The similarity in price range for check per person within this industry despite the differences in market share based on sales indicates that competition rivalry amongst firms in the industry is high, thus leading to a mixture of price-setting and price-taking within the industry. 21 P a g e

22 Differentiation Product differentiation creates a competitive advantage in price competition in the upscale casual dining industry. Competitors producing similar products in the industry allow consumers to switch firms on pure-price basis. This factor leads to companies in the industry being price-takers in terms of the similar products due to the high price competition present in an industry. In contrast, when companies offer differing products than competitors, the firm competes less on price and more on quality and service. This allows the company to be price-setters in terms of the differing products. For example, The Cheesecake Factory Inc. has product differentiation in dessert products. The menu offers approximately 50 varieties of cheesecake and other quality baked deserts. This product differentiation is a value driver and allows the company to be a price-setter for the product by offering high quality deserts, [which] results in significant level of dessert sales, approximately 15% of The Cheesecake Factory restaurant sales for fiscal 2013, 2012, and 2011 (Cheesecake 10-K). BJ s Restaurant s use product differentiation by offering as many as 30 guest domestic and imported craft beers with the [intent] to enhance BJ s competitive position as the leading retailer of craft beer in the casual dining segment. BJ s alcohol sales are a value driver of the firm in the upscale casual dining industry and represent approximately 22% of total restaurant sales in 2013 (BJ s 10-K). One of our competitive strengths is our ability to anticipate consumer dining and taste preferences and adapt our menu to the latest trends in food consumption (Cheesecake 10-K). As an example, consumers are now more concerned about what ingredients are in their food along with how healthy their food is. As a response to this recent demand of healthy living, the Cheesecake Factory has developed the SkinnyLicious menu, which offers approximately 50 innovative items at 590 calories or less (Cheesecake 10-K). 22 P a g e

23 Darden Inc. offers items at its Seasons 52 restaurant that are [no] more than 475 calories (Darden 10-K), BJ s restaurants offer a lower calorie menu category called Enlightened Entrées (BJ s 10-K), and Brinker Intl. offers a lighter choices menu that has items with less than 650 calories. These are examples of companies responding to consumer tastes and preferences using research and development as a means to differentiate products to drive value in the industry. Differentiation is also present in the firm s atmosphere and services offered. Companies in the upscale casual dining industry differentiate the atmospheres of restaurants by using décor and designs that are parallel to the firm s business strategy. The Cheesecake Factory places significant emphasis on the unique, contemporary interior design and décor of [their] restaurants in order to create a high-energy ambiance in a casual setting. (Cheesecake 10-K). Brinker Inc. differentiates their atmospheres of their restaurants based on the brand. For example, Brinker Intl. s Maggiano s Little Italy restaurant s interior design of all locations transport[s] [the] guests back to a classic Italian- American restaurant in the style of New York s Little Italy in the 1940s (Brinker 10-K). The differentiation strategy in atmospheres of upscale casual dining establishments are used as value drivers within the industry. Conclusion In the upscale casual dining industry differentiation of services and products offered drive value for the firms. The degree of differentiation is a mixture of highly differentiated and similar products and services. Companies in the industry offer many of the same menu items such as steaks, pastas, and salads. However, differentiation in specialty products such as The Cheesecake Factory s desserts and BJ s Restaurants wide variety of beer on tap are product differentiations that drive value for the companies. The service that firms provide 23 P a g e

24 to customers in the industry is similar, with all company s missions toward hospitality ensuring that guest satisfaction is of highest priority. The differentiation of concepts and atmospheres between restaurants in the industry allow customers to differentiate between the firms based on consumer tastes and preferences. Overall, differentiation of products, services, and atmospheres are value drivers within the upscale casual dining industry and cause a mix of Industry Growth Rate Industry growth rate aids business analysts in determining if an industry is either growing, declining, or is stagnate. The growth rate also helps indicate how firms should revise current business plans in order to compete for market share in the industry. When an industry is experiencing high growth companies can gain a competitive advantage by developing new products in accordance with current consumer tastes as a means to attract new consumers in order to gain share of the growing market. In a low growth industry firms compete on price in order to take business from the industry s competitors. The food service industry as a whole currently employs 13.5 million people in the United States which consists of 10% of the overall U.S. workforce. As of 2014, restaurant industry sales are projected to reach $683.4 billion, experiencing an increase of 3.6% in nominal terms (National Restaurant Association). Firms in the overall restaurant industry expand by franchising or opening more company owned stores. For the purpose of analysis the industry we are valuing is consistent of higher quality products and services, called the upscale casual dining industry. 24 P a g e

25 Sales Revenues (in thousands) Cheesecake Factory Inc. $1,602, $1,659, $1,757, $1,809, $1,877, BJ's Restaurants, Inc. 426, , , , , Darden Inc. 7,217, ,113, ,500, ,998, ,551, Brinker Intl. 3,276, ,858, ,761, ,820, ,846, Total Industry Sales 12,522, ,144, ,640, ,336, ,051, With respect to sales revenues in the upscale casual dining industry Darden Inc. holds the overall market share in comparison to other firms. The average trend in sales revenues of the industry from 2010 to 2013 is increasing for all firms in the industry. Between 2009 and 2010 however the trend in sales revenue was decreasing. The decrease in sales revenue during this time period can be attributed to the economic recession experienced in the United States. Less consumer income means less disposable income to spend on dining out, therefore leading to decreased sales in the upscale casual dining industry. Annual sales growth, pictured below, is used to analyze the percentage of sales growth that each firm experienced in the industry between 2009 and Overall industry sales did not grow and instead shrank in terms of annual sales growth between 2009 and However, between 2011 and 2013 the firms and industry as a whole experienced annual sales growth, with the total sales growth of the industry equaling 4.08%, 5.51%, and 5.36% for years 2011, 2012, and 2013 respectively. The growth, steady and not increasing exponentially, is a 25 P a g e

26 sign that the upscale casual dining industry has recovered from the economic recession during 2009 and The consistent average increase in sales growth for the industry is indicative of a high competition market within the industry, thus leading to a mixture of price-setting and price-taking tendencies by firms within the industry. Conclusion The upscale casual dining industry, consisting of The Cheesecake Factory Inc., Brinker Intl., Darden Inc., and BJ s Restaurants, Inc., shows to have recovered from the economic recession taking place during 2009 and 2010 with a positive and consistent growth rate in years 2011, 2012, and The consistent average increase in sales growth of the industry as a whole indicates a highly competitive market that is currently expanding, resulting in a mix of pricetaking and price-setting between the firms of the industry in order to increase profitability. 26 P a g e

27 % of Sales Growth Annual Sales Growth % Cheesecake Factory Inc BJ's Restaurants, Inc Darden Inc Brinker Intl Total sales growth of industry Economies of Scale In the upscale casual dining industry learning curves of products are pivotal to being able to gain share of the market and increase sales. Steep learning curves and the presence of other scale economies in the industry require having enough capital and resources as a firm to achieve a learning economy. Learning economies will result in quicker development of products that target ever changing consumer tastes in an effort to gain a greater share of the market. Below is the total assets of each firm in the upscale casual dining industry we are valuing. 27 P a g e

28 $8,000,000 Total Assets (Thousands) $7,000,000 $6,000,000 $5,000,000 $4,000,000 $3,000,000 $2,000,000 $1,000,000 $ Cheesecake Factory BJ's Restaurants Brinker Intl. Darden Inc. In the industry that we are valuing the overall size of the firm in terms of assets allows opportunities for more research and development of new ideas and products due to having more capital. Darden Inc. captures approximately 60% of sales revenue in the market for the industry and in correlation has the highest amount of assets of any firm in the industry. By having more available assets to use for capital Darden creates learning economies through product development, thus capturing a greater share of the market in the upscale casual dining industry. Another example of using assets to develop learning economies of scale is vertical integration of inputs and outputs of a firm. For example, The Cheesecake Factory Inc. vertically integrated its bakery production, Vertical integration of this vital part of our brand gives us control over the creativity and quality of our deserts and is also more profitable than buying from a third party (Cheesecake 10-K). Vertical integration of bakery production creates an economy of scale for The Cheesecake Factory in the industry. Controlling inputs and outputs of the production process allows the firm to control costs of products and has led dessert sales to account for 15% of restaurant sales. 28 P a g e

29 Conclusion Economies of scale allow firms in the industry to control inputs and outputs of production process, possibly lowering costs related to specific products of a firm. Economies of scale are achieved in industries with steep product learning curves by using capital as a means to develop learning economies. Overall size of the firm in an industry affects the development of learning economies and economies of scale due to the amount of assets a firm has to put forth to product development. Economies of scale allow firms to compete on costs and results in price-setting within the industry. Switching Costs When a firm is contemplating discontinuing operations in its current industry and plans to enter another industry the firm will incur switching costs. Switching costs in the restaurant industry are high, with property and equipment specifically designed and produced for the purpose of restaurants. In the upscale casual dining industry switching costs are high due to the high quality products and services the firm offers. Ceasing operations in the industry would require firms to sale supplies that are specific to the restaurant industry, thus having little value to other industries. Kitchen supplies, décor, and fixtures within the restaurant would be liquidated in order to exit the industry. Liquidating assets can result in losses, thus increasing switching costs for the firm. Along with costs to exit the industry a firm may incur costs to enter a new industry. Purchasing of new assets related to the new industry, legal costs, as well as a restructuring of business strategy are all factors associated with switching costs for a firm. 29 P a g e

30 Conclusion Switching costs are costs that are related to ceasing operations in one industry and beginning operations in a different industry. In the upscale restaurant industry switching costs are high for firms due to the specialized products used within the industry such as dining room furniture and heavy kitchen appliances. Due to the high degree of switching costs firms are discouraged from exiting the industry and thus create a highly competitive market amongst firms in the industry. Excess Capacity Excess capacity occurs when the overall production is greater than the consumers demand for products. High excess capacity results in increased inventory expenses and unsold products increase the costs of goods sold. In order to contain excess capacity to an acceptable level firms in the upscale casual dining industry schedule inventory shipments based on current demand of products. For example, The Cheesecake Factory Inc., [negotiates] short-term and long-term agreements for the supply of inventory and equipment requirements depending on market conditions and expected demand (Cheesecake 10-K). By negotiating inventory shipment dates with suppliers, firms in the industry control the level of excess capacity in the company. The agreements help companies maintain stock and hedge against over stocking in order to reduce costs related to inventory. An industry s excess capacity can be measured by dividing the total sales by Plant, Property, and Equipment. The measure determines if the firms fixed costs are producing profits for the company. The goal is to maintain a high sales to plant, property, and equipment ratio in order to avoid pricing wars amongst 30 P a g e

31 industry competitors. Below is the excess capacity ratios of the industry we are valuing Excess Capacity (Sales/PPE) Cheesecake Factory Inc. BJ's Restaurants, Inc. Darden Inc. Brinker Intl. Industry Threat of New Entrants In the upscale casual dining industry the threat of new entrants is low due to the market being relatively saturated. There are barriers to entry because there are multiple firms that are established in the industry. Due to larger firms being established, entering the industry is difficult due to market share already being taken by other companies. A firm would have to compete on costs, which is what the already established firms are already competing on. Also, a new firm would have to compete against the brand value of the already established firms. By entering a new market a new firm has to establish an economy of scale to compete with the other firms. This can be difficult due to the new firm having to create new relationships with their suppliers. Also, a new firm has little negotiating power compared to firms that are already established and have been in a relationship with their suppliers for an extended period of time. 31 P a g e

32 Threat of Substitute Products Customers will think alternative products or services are substitutes based on the price difference, how different a products function is, and how willing they are to switch to another product. With such low concentration in the upscale casual restaurant industry, the availability of substitutes is high. Relevant substitutes are not necessarily those that have the same form as the existing products but those that perform the same function. For example, airlines and car rental services might be substitutes for each other with it comes to travel over medium distances. (Palepu) Because there are so many possible substitutes, we believe that it is important to obtain differentiation. Offering customer satisfaction, superior quality products, and a unique environment will help a company develop brand loyalty and competitive advantage over competitors. By minimizing your product cost and offering a reasonable price per plate allows you to compete on cost. On the other hand, there will always be substitutes. Focusing on these business operations can give you a competitive advantage. This reduces the chance of customers going elsewhere and will potentially increase brand loyalty. Bargaining Power of Suppliers The bargaining power of suppliers in the upscale casual dining industry is low. The companies in the industry mainly obtain their goods through suppliers that they have negotiated long term contracts with (CAKE 10K) and therefore the suppliers have very little control over who they supply to and by how much once the contracts are signed. This results in very little bargaining power of suppliers since the only chance they have to negotiate is during the contract negotiations 32 P a g e

33 and even then the volume of suppliers in the industry is very large which creates very little room for the suppliers to negotiate a price they want. This method of contract negotiation allows the companies in the industry to use a cost control method to keep the suppliers from changing prices on them. Once the contracts are signed and the prices are negotiated, the supplier has no ability to change their prices or stop supplying these companies. Because of this the companies can maintain a consistent cost allocation to supplies that allows them a high degree of flexibility with their other expenses. Due to this the suppliers have very little bargaining power within the upscale casual dining industry. A high volume of suppliers creates little room for the suppliers to negotiate prices when writing up a long term contract with these companies. This creates a large amount of flexibility for the companies and next to nothing for the suppliers. Bargaining Power of Customers The bargaining power of customers is directly correlated to the threat of substitute products and whether or not the product being supplied is a commodity or a necessity. The upscale casual dining industry provides a commodity service and there is a high threat of substitution within the industry that creates a very high degree of bargaining power for the customers. As evidenced by the financial statements from each company s 10K, when the economy crashes the upscale casual dining industry takes the crash very hard. Sales decreased substantially across the board which ultimately negatively affected net income and retained earnings. This was all caused by the fact that the industry provides a commodity service and the consumer base can substitute that product with cheaper 33 P a g e

34 alternatives. This causes a massive backlash to the industry because the value drivers that these companies use to obtain and retain business are rendered useless because the customer has enough bargaining power that they can choose to not utilize the product supplied whenever they want. Because of these reasons we have concluded that the customers have a very high degree of bargaining power within the upscale casual dining industry. The ability for the customers to come and go as they please due to the high availability of substitute products creates a very large amount of bargaining power that the companies in the industry must follow. These companies do not offer anything that the consumer needs to have that they cannot get anywhere else. Analysis of Key Success Factors for Value Creation in the Industry We have discussed how the five forces model can influence the profitability of an industry as a whole. Now, we will express our analysis on the industry's business activities that can add value and also create a competitive advantage. There are two primary categories for achieving competitive advantage cost leadership and differentiation. After analyzing The Cheesecake Factory and its competitors, we have determined our industry is primarily price setters with a little price taking. 34 P a g e

35 Cost Leadership Cost leadership is supplying the same product or service at a lower cost. (Palepu) It is possible to achieve a competitive advantage by cost leadership from the following: economies of scale and scope, efficient production, simple product designs, lower input costs, low-cost distribution, little research and development or brand advertising, and also tight cost control system. (Palepu) However, in the upscale casual restaurant industry, we think it s necessary to focus on achieving economies of scale and a tight cost control system. Economies of Scale Economies of scale are a cost benefit a firm receives whenever they buy, produce, or sell a large quantity of a product. The more the firm is able to produce or sale, the more they fixed cost-per unit is going to decrease. In the restaurant industry, with such a low concentration, it s critical to the companies in the industry to get inputs at a cheaper cost than competitors. The Cheesecake Factory has 181 company restaurants and is also currently expanding into the Middle East and Mexico. The firm has a bakery in California and North Carolina. In this upscale casual industry firms are constantly expanding not only nationally but also globally. Based on the information above we ve concluded that it s important to take advantage of the cost benefit from economies of scale. The more restaurants a firm has the more inputs it will need. Having 2 bakeries makes it possible for them to make their own products and offer a lower cost than their competitors. 35 P a g e

36 Tight Cost Control System No matter the industry a company is in, every company is always seeking to minimize cost. Obtaining a tight cost control system can be difficult to achieve if a company s budget is not tight. A way of cutting cost within a company can be done by observing business operations over time and looking for possible trends. Substantially all of our food and supplies are available from multiple qualified suppliers, which helps to diversify our overall commodity availability and cost risks. Independent foodservice distributors, including the largest foodservice distributor in North America, deliver most items multiple times per week to our restaurants. We attempt to negotiate short-term and long-term agreements for our principal commodity, supply and equipment requirements, depending on market conditions and expected demand. (CAKE 10-K) After analyzing the information above, we as a team of analyst have determined that having multiple suppliers is beneficial because it ensures quality products. It also prevents a company from putting all of its eggs in one basket. Having high quality distribution is important because the firms in the industry can t sell something if they can t make it. The Cheesecake Factory also hedges for better prices by negotiating short and long term contracts with its suppliers. Differentiation We believe differentiation is the primary target for the upscale casual restaurant industry. Specializing in differentiation, companies are able to set prices for unique characteristics that they have. Differentiation is supplying a unique product or service at a cost lower than the price premium customers are willing to pay. (Palepu) The ways the industry achieves differentiation are by having superior product quality, superior product variety, superior customer 36 P a g e

37 service, more flexible delivery, quality investment in brand image, investment in research and development, and control system focus on creativity and innovation. In the upscale casual restaurant industry, we believe it s important to achieve product quality, customer service, and a brand image. Superior Product Quality Customers in the upscale casual restaurant industry pay the extra cost for the high quality food. A superior product makes people not only remember the company but also makes them want to return for more. As of February 27, 2014, we operated 181 Company-owned upscale, casual, full-service dining restaurants. (Cheesecake 10-k) The Cheesecake Factory also prepares their menu items fresh from scratch daily, use all natural chicken with no hormones, and premium beef that is Certified Angus, U.S.D.A. (Cheesecake Investors) Most chains in this industry have a lot of restaurants. We think it is important that a guest can have a good quality meal in Texas and then goes to California and have the same meal. The quality of the inputs should be equally superior at all locations. In this upscale industry it only takes one mess up to lose a customer, and providing superior quality products at all locations will prevent this from happening. This will create a brand image and keep loyal customers returning. Superior Customer Service When customers pay extra for a quality product they expect the service as well. Service in the upscale casual industry is to be superior to the rest. Commitment to excellent service and hospitality through the selection, training 37 P a g e

38 and retention of high quality staff members. Our mission is to create an environment where absolute guest satisfaction is our highest priority. We strive to consistently exceed the expectations of our guests in all aspects of their experience in our restaurants and with our bakery products. (Cheesecake 10-K) As a team of analysts we think providing superior customer quality service is one of the most critical factors in achieving a competitive advantage. Employees must be experienced and knowledgeable in order to exceed guest expectations. Also, employees need to dress professionally. Attire helps set the more upscale atmosphere. Overall, employees should focus on doing whatever necessary to have customers leave with the feeling of satisfaction. Investment in Brand Image Achieving a good brand image is necessary to gain people s trust. Whenever people talk about a company they should only say positive things by the experiences they have had in the past. Having superior quality products and superior quality customer service at one location is just as important as having those at every other location. This comforts people in knowing that you re going to get the quality service you pay for everywhere you go and not just a specific location. Our restaurants distinctive contemporary design and décor create a high energy, non-chain image and upscale ambiance in a casual setting We apply high standards to the maintenance of our restaurants to keep them in like new condition. (Cheesecake 10-K) The feeling you get whenever you go to a restaurant chain should be unique to others. Having a clean and like new feeling impresses customers and leads to improved customer satisfaction that leads to people talking about a company which increases overall traffic. 38 P a g e

39 Conclusion Overall, in this upscale casual restaurant industry we think it s important to target differentiation with some cost control. This allows the companies to develop superior business strategies that add value to their respective company and help themselves stand out to competitors. All of these key success factors assist the companies in gaining a competitive advantage over competition and most importantly to increase shareholder s wealth. Firm Competitive Advantage Analysis Superior Product Variety At first glance, the Cheesecake Factory s menu can be slightly intimidating. It features over 200 items to choose from and a variety of food types. Considering that you can get anything from a steak, to pasta, it seems to us that the Cheesecake Factory is a great compromise to take a family that can t decide on a place to eat. The Cheesecake Factory s menu serves pizzas, burgers, sandwiches, pastas, seafood, steaks, and salads. Recently the Cheesecake factory came out with their Skinnylicious Menu. It contains over 40 meals and 5 drinks that are healthier alternatives to the other options. The Cheesecake Factory also features a diverse desert menu with over 50 different types of cheesecakes. In addition to their food, the Cheesecake Factory has an abundant drink menu featuring specialty drinks, cocktails, mojitos, margaritas, martinis, and an impressive beer and wine selection. Their beer selection varies depending on the location so they can offer local brews as well as the national know beers. 39 P a g e

40 They offer wines from California, Washington, Europe, South America, and Australia ranging from $7.95-$12.95 per glass. The selection of food and drink show us that The Cheesecake Factory utilizes product differentiation as a major value driver. In order to separate themselves in the industry they must use product differentiation to maintain business. Superior Product Quality In our opinion, the fact that the cheesecake factory makes all of their meals from scratch daily gives them a huge advantage over some of their other competitor chains. They will also cater to every one of the diner s needs. We will gladly honor requests to modify your order to suit specific health or dietary needs (Cheesecake Investors). The Cheesecake Factory also sells their famous cheesecakes to other restaurants. To guarantee their superior food quality, the Cheesecake Factory claims to use only the highest quality ingredients to produce the best product. We believe that this product quality is leaps and bounds beyond their industry competitors. The flexibility The Cheesecake Factory has with its products and customer service represent a superior product quality, another value driver for the company. In order to compete in the industry the company must maintain this level of quality to pull business from the competition. Locations and Future Growth The Cheesecake Factory has become an international brand name. Cheesecake Factory has 169 locations in the United States including Puerto Rico. In 2012, the Cheesecake Factory expanded its international boarders to the United Arab Emirates, opening in the Dubai Mall, and in 2013, another location 40 P a g e

41 opened in the Mall of the Emirates. The Cheesecake Factory also came out with 2 different restaurants, the Grand Lux Café and Rocksugar Pan Asian Kitchen. The Grand Lux Café, which serves American, European, Thai, and Caribbean cuisine, has 11 locations featured in the United States. The Cheesecake Factory opened the Rocksugar Pan Asian Kitchen in 2008 with their only location in Los Angeles. By the end of 2014, the Cheesecake Factory plans to open several more locations in the U.S. and plans to have 3-5 locations in the Middle East (thecheesecakefactory.com). We believe that with the amount of locations, both nationally and abroad, and the plan for future growth gives the Cheesecake Factory staying power. The way The Cheesecake Factory grows is by building new restaurants. By showing us that they are aggressively expanding, not only in the US, but in foreign countries as well, we see that The Cheesecake Factory plans to stay competitive with its growth. Strengthening Brand Image The Cheesecake Factory s community involvement and charitable giving s have helped strengthen the Cheesecake Factory s brand name. They are involved with several charities including: Feeding America, The Salvation Army, City of Hope, and The Harvest Food Donation Program. On Thanksgiving Day, the Cheesecake Factory s staff members volunteer at their local Salvation Army. They prepare and serve an elaborate Cheesecake Factory traditional holiday 41 P a g e

42 meal to thousands of disadvantaged individuals and families at Salvation Army Community Centers across the country (thecheesecakefactory.com). For City of Hope, they host an annual golf tournament and auction fundraiser. Together with their vendor partners, they have donated more than $2.1 million to City of Hope. Through the Harvest Program, they donate all of their surplus food to local soup kitchens, shelters, and after-school programs. Through this program, they have donated more than 500,000 pounds of food each year. In addition to these charities, they also contribute through their very own Give back Foundation Team Sponsorship by getting involved with local communities and non-profit organizations. In our opinion, all of their charitable donations and community service have helped to improve their brand name. Now people don t just like the Cheesecake Factory for their cheesecakes, but they also like the fact that they are getting involved in their community. This shows us that the Cheesecake Factory isn t only concerned with what s going on inside their restaurant walls and are focused on improving brand recognition nation-wide. Accounting Analysis After analyzing the business strategies, we ve determined the key value drivers, risks, and potential industry profitability by using Porters Five Forces Analysis. We then used qualitative measures to determine whether a firm is able to sustain a competitive advantage. Now, we will perform step three of analyzing corporate financial statements, an accounting analysis. Accounting analysis evaluates accounting quality by assessing accounting policies and estimates The purpose of accounting analysis is to evaluate the degree to which a firm s accounting captures its underlying business economics. (palepu) We have performed an accounting analysis to potentially discover any distortion and biased information in the financial statements. Distortion is caused 42 P a g e

43 by the flexibility allowed to a firm s management from the Generally Accepted Accounting Principles. Management is given flexibility so they can show the financial position of the firm. However, they can often be inclined to manipulate and forecast their financials to benefit them personally. They could have a lot of stock in the company, quarterly targets to hit, and questionable job security. It is our job to undo any biased opinions or distortion. In order to undo distortion and biased opinions from management we will perform an accounting analysis that consists of 6 steps. First, we have to identify the accounting policies. This involves the analyst identifying and analyzing the firm s policies and estimations. Next, we will assess the degree of flexibility given to a firm. When management does the firm s financials they have to make estimations. They also might be inclined to make biased decisions for their personal benefit. The third step is to evaluate the accounting strategy. Evaluating the accounting strategy looks for possible causes of distortion and biased opinion. The fourth step is to determine the degree of disclosure. If management doesn t disclose all the necessary information and make it easily assessable, it can have a negative impact on the quality of the firms accounting. This would lead to the firm presenting skewed information to potential investors and stockholders giving them a misleading idea of what s going on internally. The fifth step of the analysis is to identify potential red flags. We will look for any information presented that could point to any questionable accounting. Finally, the last step of the analysis is to undo any accounting distortion by restating the firm s financials to eliminate any distortions in the financials. 43 P a g e

44 Key Accounting Policies After analyzing the firms within the industry, we have determined the key accounting policies by focusing on success factors that will provide the company with a competitive advantage. If key accounting policies can t be linked to success factors, it will possibly signal a red flag thus needing to be further analyzed. The key accounting policies are important because estimations and forecasting have to be done whenever the financials are created. There are two types of accounting policies. Type I accounting policies can be directly linked to the key success factors. In the upscale casual industry we believe economies of scale, superior customer service, and superior product quality are critical accounting policies. Type II accounting policies are policies that can potentially distort our view of the financial position of the company. We feel capital vs. operating leases, disclosure, and assumptions are the main type II policies. Type I Accounting Policies Type I accounting policies can be directly or indirectly related to the key success factors of a firm. In the upscale casual restaurant industry we have identified 3 main policies that are economies of scale, superior customer service, and superior product quality. Economies of Scale Economies of scale play an important role in cost leadership. Economies of scale can be achieved from lowering the fixed cost per unit by increasing output or production. An idea is to grow a company s locations. This will lead to larger purchases from a company s suppliers. With larger purchases a company can negotiate short and long term contracts to hedge prices. The Cheesecake Factory 44 P a g e

45 has many suppliers and hedges their prices by using contracts. In the Cheesecake Factory s 10K, it states how they use short term and long term contracts for their main commodities. This enables them to get their inputs at a lower cost and also ensures quality products. The Cheesecake Factory also maximized economies of scale by using vertical integration. Vertical integration of this vital part of our brand gives us control over the creativity and quality of our desserts and is also more profitable than buying from a third party. The Cheesecake Factory has a bakery in California and North Carolina. We believe by being able to hedge input prices and produce their own goods allows them to take advantage of economies of scale. Fiscal Year Average sales per productive square foot By looking at the table above, we as a group of analysts have concluded that The Cheesecake Factory is achieving economies of scale by increasing average sales per square foot. The Cheesecake Factory targets total costs of about $700-$800 per square foot. We believe by closing non-profitable locations, increasing menu prices by 1-2% every year, and hedging input costs by negotiating short and long term contracts have all attributed to increasing their profits. On May 19, 2014, The Cheesecake Factory Incorporated announced that it was entering into an exclusive licensing agreement with an operator in Asia. This agreement would provide for a minimum of 14 restaurants over the next P a g e

46 years in various countries. The first restaurant is expected to open sometime in their fiscal year (investors.cheesecake.com) CAKE is showing future expansion growth as well in the present. They ve increase capital investment about 38.5% since fiscal year Fiscal Year Additions to property and equipment 76, , , Superior Customer Service In the upscale casual restaurant industry, we believe superior customer service and hospitality is extremely vital to success. Customers pay top dollar for a meal and it is imperative that they are treated as so. In the Cheesecake Factory 10-K it states Our recruitment, selection, training and retention programs are among the most comprehensive in the restaurant industry, enabling us to attract and retain qualified staff members who are motivated to consistently provide excellence in guest hospitality. This tells us they put a strong emphasis on hiring good employees, training them to serve professionally, focusing on customer retention, and offering customers a superior experience to make guests return. 46 P a g e

47 Superior Product Quality Superior product quality is extremely important because customers go to a upscale casual restaurant for the quality of the product and the experience. If the quality of the product is sub-par then the customer is unlikely to return because they will feel like they didn t get their money s worth. The Cheesecake Factory makes their products handmade fresh daily using high quality products and fresh ingredients using innovative and proprietary recipes. (CAKE 10k) When analyzing information given within the 10k of a company, we can determine the firm s financial position among other things. Managers should present both good and bad information that could help make a decision in the company s financial standing. However, what is presented might not be very transparent. Good disclosure is when information represented in a firms financials, estimations, and business activities are transparent. Financial statements can also be misleading due to the amount of flexibility given to a firm s management by GAAP. Flexibility allows for estimations to be included and also allows for management to manipulate certain things to portray a better financial statement than they currently are in. Fiscal Year Intangible assets, net N/A 14,482 14,674 17,829 18,647 Total Assets N/A 1,037,307 1,022,570 1,092,167 1,124, Goodwill isn t directly stated in the 10k. As a team of analysts we ve come to the conclusion that goodwill is included in intangible assets. Intangible assets are less than 2% and not at the threshold. Other relevant information that helps investors make decisions such as discount rates and suppliers should give, 47 P a g e

48 however, The Cheesecake Factory doesn t think it s too important. They aren t supplying enough material and transparent information and can prevent analyst from being able to see the underlying economic value in business activities. This is why we have decided the Cheesecake Factory has a low quality of disclosure. Type II Accounting Policies The Type II accounting policies lead to distortion. Distortion hides or covers material information and can lead investors to believing a firm is doing better or worse than it actually is. In the upscale casual restaurant industry we believe leasing is the most important policy. Operating Leases A lease is an agreement between two parties that allows the usage of land, buildings, property or equipment. There are two primary methods of recording your lease. The first is a capital lease which recognized the asset and liability on the balance sheet. The other method is an operating lease. The operating lease does not claim the rights or ownership on the balance sheet and just expenses the rent under operating expenses. Capital leases are considered equivalent to a purchase, while operating leases cover the use of an asset for a period of time and are treated by the lessee as periodic expenses. (fasab.gov) A capital lease shows transfer of ownership, rights, and liabilities when the lease is signed for. They are shown on the balance sheet as an asset under PPE and a liability such as Capital Leasing Liability. There are four main criteria that constitute a capital lease: Ownership of Property The lease will transfer ownership to the person leasing at or before the ending lease date. Bargaining Option The lease allows for purchase of the lease 48 P a g e

49 property at a discounted price. Estimated Economic Life The leasing term must be equal to or greater than 75% of the estimated life of the property. Fair Value The present value of rental and other minimum lease payments, excluding that portion of the payments representing executory costs, equals or exceeds 90% of the fair value of the leased property. (fasab.gov) If the leasing term is after 75% of the estimated economic life then the last two do not apply. Operating leases are the only type of lease used by The Cheesecake Factory. An operating lease is an agreement conveying the right to use property for a limited time in exchange for periodic rental payments. (fasab.gov) They do not assume the risk or ownership of PPE nor does it recognize the PPE on the balance sheet. Rent payments are just expensed as an operating expense on the income statement. Operating leases have less disclosure. By not having operating leases on the balance sheet it also doesn t show any type of A/D or interest expenses for the capital. This can lead to understating expenses thus overstating net income and retained earnings. Conclusion In conclusion, a firm can look at their key success factors and distortion and then determine their type I and type II accounting policies. There will always be estimations and distortion within financial statements due to flexibility. We were able to identify firms with biased and misleading accounting. Because of this we are able to look past the distortion and see the true value of the financials. 49 P a g e

50 Assess Degree of Accounting Flexibility Accounting flexibility is the level at which managers can choose their company's accounting policies. Accounting flexibility is dependent upon GAAP and the other standards that financial filings must follow. Highly flexible companies have more room to account in ways that the managers see fit. This will generally result in the company looking much better than if the accounting flexibility were lower. The accounting flexibility of the Cheesecake Factory, as well as the industry, have been analyzed below by looking at three key business activities that are affected by the accounting flexibility of the companies. The two business activities that we have analyzed are Operating vs. Capital Leases and Goodwill. Operating vs. Capital Leases The restaurants that make up this industry have a high amount of flexibility with the decision to classify their leases as operating or capital leases. Capital leases show up on the financial reports while operating leases do not. Capital leases are accounted for as an asset and liability when the contract gets finalized while operating leases get treated as rent expense to be recorded each period as it gets paid. The problem with this is that the company makes a large asset deposit in prepaid rent. Cheesecake Factory records each lease it signs as an operating lease and the industry as a whole classifies almost all of their leases as operating leases (CAKE 10-K, Darden 10-K, Brinker 10-K, BJ's 10-K). The high degree of accounting flexibility that these companies have in their choice of lease classification results in misstated financials. These misstatements will be represented in the table below. 50 P a g e

51 Assets Liabilities Equity Revenues Expenses Net Income Overstated Understated N/A N/A Understated Overstated Due to the prepaid rent, the assets are overstated resulting in an understatement of liabilities because the rent expense is not being properly stated. At the same time the expenses are understated which results in net income becoming overrated. This makes the company look more profitable than it actually is. Goodwill Goodwill is an asset (or rarely as a liability recorded as a loss) account that the industry has a high degree of flexibility on. When goodwill is recorded as an asset it is filed under intangible asset that has zero material value to the company. The industry has flexibility with goodwill because the companies do not have to break down their intangible assets account to provide any detail as to whether the company even has any goodwill. The Cheesecake Factory records their financials this way so goodwill does not show up anywhere in their financials. As with the compensation plans, we have looked at the industry as a whole to analyze goodwill industry-wide. In order for goodwill to be considered material and affect the financials it needs to be greater than 20% of the fixed current assets of the company. After pulling the financials for Brinker International, Darden Inc., and BJ's it was determined that goodwill is less than 20% of fixed assets and is immaterial (Brinker 10-K, Darden 10-K, BJ's 10-K). 51 P a g e

52 Conclusion Almost all of the leases used by the industry are recorded as operating leases which result in overstated assets and net income on these companies' financials. Goodwill is also a highly flexible account because the company's don't have to put it on the statements if they choose not to specify what goes into intangible assets. The Cheesecake Factory takes advantage of this and only records the total intangible assets without specifying what exactly makes up the account. Therefore, after analyzing the upscale dining industry's financials and accounts that are affected the most by accounting flexibility, we have determined that the industry has a high degree of accounting flexibility. Evaluation of Actual Accounting Strategy As explained earlier, accounting flexibility allows managers of a company to use strategies and loopholes as a means to communicate or hide the firm s current economic situation or performance during a period. By using accounting flexibility companies can either be aggressive or conservative in their accounting strategy as a means to distort information in their favor. A firm that employs an aggressive accounting strategy will overstate its assets and understate its liabilities in order to increase equity and net income on the balance sheet. In doing so the firm distorts the financial information in its favor, making it appear as if the company is better financial position than it may actually be. In contrast, a firm that employs a conservative accounting strategy will understate its assets and overstate its liabilities in order to decrease equity and net income on the balance sheet. This strategy can result in managers using big bath accounting as a means to distort information due to hard economic times or a period of loss within the company. 52 P a g e

53 Being able to identify a firm s accounting strategy allows us, the financial analysts, to be able to gain an insight on the firm s current financial position. Due to accounting regulations by GAAP, a firm s financial statements will be fair and transparent in its presented information. However, companies have the option of choosing the amount of information to disclose on the financial statements. Companies with high transparent disclosure present valuable information such as interest rates used on operating and capital leases. Companies with low disclosure, such as The Cheesecake Factory, fail to disclose information such as interest rates and information regarding goodwill. Firms that present the minimum amount of information required are attempting to conceal information from investors and the outside public, making the process of valuing a firm more difficult. Therefore, in order to be fully understanding of a firm s performance and value, it is critical to evaluate the accounting strategies used by the firm. Capital and Operating Leases In the restaurant industry capital and operating leases play a major role in financing properties for a firm. As previously stated, The Cheesecake Factory does not completely own all of its properties and therefore uses operating leases, All of our restaurant leases are classified as operating leases (Cheesecake 10- K). Similarly, in the industry that we have defined as upscale casual dining, BJ s Restaurants Inc., uses all operating leases as well, All of [their] restaurant leases are classified as operating leases (BJ s 10-K). In contrast to BJ s and The Cheesecake Factory, Brinker Intl uses both capital and operating leases We lease certain buildings under capital leases we lease facilities and office space under operating leases (Brinker 10-K) along with Darden Inc., For operating leases, we recognize rent expense on a straight line basis.capital leases are recorded as an asset (Darden 10-K). 53 P a g e

54 In terms of disclosure of information with regards to operating leases, The Cheesecake Factory states in their 10-K that Minimum base rent, which generally escalates over the term of the lease, is recorded on a straight-line basis over the lease term. The initial lease term includes the build-out, or rent holiday, period for our leases, where no rent payments are typically due under the terms of the lease. Contingent rent expense, which is based on a percentage of revenue, is recorded as incurred to the extent it exceeds minimum base rent per the lease agreement (Cheesecake 10-K). Although this explanation is filled with words that seem to explain their operating leases, it is confusing and misleading and presents no real relevant information regarding the leases such as the discount rate used or how long leases are contracted for. As compared to the industry, The Cheesecake is a low quality, low disclosure company in terms of presenting operating lease information on the financial statements, with Brinker Intl., Darden Inc., and BJ s Restaurants all presenting information in their financials regarding discount rates and lease length. The Cheesecake Factory is aggressive in terms of utilizing operating leases as a means to finance its property in regards to accounting, with 100% of their leases being operating leases. The upscale casual dining industry as a whole is aggressive in their accounting strategy in terms of operating leases, with all of the companies in the industry having above 85% of leases being operating leases, as shown in the table below. Percentage of Leases by Type 2013 Operating Lease Capital Lease The Cheesecake Factory % 0.00% BJ's Restaurants Inc % 0.00% Brinker Intl % 12.99% Darden Inc % 7.14% 54 P a g e

55 Although the disclosure of operating lease financials is low quality in regards to The Cheesecake Factory Inc., operating lease financials will be capitalized and disclosed on the restated financials for the firm. Goodwill In the defined upscale casual dining industry Goodwill is disclosed in the financial statements of Brinker Intl., Darden Inc., and BJ s Restaurants Inc. In contrast, The Cheesecake Factory presents no information regarding the disclosure of Goodwill, with goodwill appearing a total of zero times in the company s 10-K. Due to goodwill not being disclosed at all in the financial statements, it will not be in the restated financials for the firm. Research and Development The Cheesecake Factory Inc. does not present any disclosure in terms of research and development on the financial statements. The upscale casual dining industry as a whole fails to provide minimum disclosure in regards to research and development. Therefore research and development will not be included in the restated financials as it is irrelevant to valuing the firm and industry as a whole. Conclusion Based upon evaluating the firm s accounting strategy, we the analysts have come to the conclusion that The Cheesecake Factory has an aggressive accounting strategy that is also present in the industry as a whole. Overall, The Cheesecake Factory does a poor job in disclosing information regarding operational and capital leases as compared to the industry. 55 P a g e

56 This low quality of disclosure can be difficult to investors and the outside public when determining the overall value of the company. The firm fails to disclose any information regarding goodwill, in contrast with the other firms in the industry providing some disclosure, therefore it will also not be used when restating the financial statements. The industry as a whole fails to provide minimum financial information regarding research and development. This is due to the restaurant industry not being a research and development focused industry. This also applies for The Cheesecake Factory Inc., as there is no mention of research and development financials in the financial statements. The low quality of disclosure makes research and development irrelevant in terms of restating the financial statements. Qualitative Analysis It is important to assess the quality of information provided by the companies 10-K. The greater the quality within Cheesecake Factory s 10-K the more the information is provided to potential investors and shareholders. Managers of the company have the ability to decide the amount of information to be disclosed in the financial statements, however there are GAAP requirements that must be met first. Therefore, there is a possibility that public companies may not choose to share data that could negatively affect their business. It is up to the reader of the financial statements, such as us, to interpret the information we are given and to understand the reasoning why certain information is disclosed clearly or vaguely or not at all. Cheesecake Factory overall does a poor job of disclosing vital information to the readers of their 10-K. Interest rates associated with liabilities and leases are not stated specifically. Also, important information about suppliers is not provided either. Compared to their competitors, Brinker, BJ s and Darden, the 56 P a g e

57 quality of Cheesecake s disclosures fail to be at the same level of standard with the industry. Specific and useful information is throughout each of the three competitors 10-K. However, there is still areas of the 10-K where the information is very transparent for us to continue on our valuation of The Cheesecake Factory. Superior Product & Service Quality Cheesecake Factory mentions clearly throughout their 10-K about their superior product and service quality. The transparency of this disclosed information is very clear, as data on quality of service and product is repeated often. Cheesecake Factory s 10-K explains the variety of menu items that can be selected at their restaurants. There is information on the distributors of supplies as well as the troubling risk of cost fluctuations with certain supplies such as milk and fish. There is also disclosed area about the quality of employees and service provided by Cheesecake Factory. They are proud of their staff e and offer incentive programs to retain them to keep their financial performance stable. The disclosure of the superior product and service quality is clearly stated, which allows others who read their 10-K to identify their key accounting policies. At the beginning of our evaluation of accounting analysis we have classified superior service and product quality as type 1 accounting policy. 57 P a g e

58 Operating Leases Cheesecake Factory limits their disclosure about their operating leases. The only information is that leases are contingent with a percentage of sales. In the 10-K they choose to give a percentage of from 3 10%. This leads to a problem with restating financial statements. In order for us to restate the financials we have to calculate estimate that we see fit based on the given numbers for sales and leases provided in the 10-K. This lack of information also prevents to see the opportunity cost of choosing to do a capital lease rather than operating. Potential Red Flags While identifying potential red flags for the Cheesecake Factory, it is important to remember that red flags don t necessarily mean any fraudulent activity is going on. Red flags are just identified as part of the firm s financials that need to be reviewed and potentially restated. Red flags, in the financial statements, could include a number of things from asset write-offs, to fourth quarter adjustments, as well as special purpose entities. In any case, these are identified as red flags because they are not very well understood or unusual, no matter if they appear to be good or bad. This is vital to analyzing the company because once a red flag is found, the distorted balances must be restated to disclose as much information to the investors as possible. As far as the Cheesecake Factory s financial statements, there was one red flag that was raised pretty quickly. 58 P a g e

59 Operating Leases An operating lease is a short-term, cancelable lease. It is a type of lease in which the contract period is shorter than the life of the property or equipment, and the lessor pays all maintenance and servicing costs. As it states in the Cheesecake Factory s 10-K, We lease all of our restaurant locations under operating leases. The Cheesecake Factory legally treats all of their leases as operating leases, but it s still something worth taking a second look at. It s worth noting that it is very common for companies in the restaurant industry to mainly classify their leases as operating leases. The reason we marked this as a red flag was, by doing this, it is very possible they are reporting inaccurate information. Since all of the Cheesecake Factory s leases are classified by them as operating leases, the Cheesecake Factory has been overstating their assets. In addition to this, there is also great lack of information about the leases that are disclosed by the Cheesecake Factory. They neglect to disclose information regarding the operating lease rate. So we were left to improvise with our own operating lease rate. To get this, we divided total lease expenses by total sales because in Cheesecake Factory s 10k, they stated that to get their discount rate they use a percentage of sales ranging from 3%-10%. Every time we computed this, it came out to approximately 7%. The lack of information also prevents us from calculating the opportunity cost of choosing operating over capital leasing. In closing, since the Cheesecake Factory classified all of their leases as operating leases to overstate assets, it will be necessary to restate their financials in order to clarify the information for investors. 59 P a g e

60 Accounting Distortions After analyzing red flags and looking closely at the financials we determined that the only distortion on the financials for The Cheesecake Factory is operating leases. Operating leases need to be capitalized otherwise assets and net income will be overstated. Below is a table that shows the as stated total assets, total liabilities, and adjustment and then the restated accounts after capitalizing the operating leases. Restatement table (In thousands) (All information from CAKE 10-K) Years Rate As stated Assets As stated Liabilities Capitalization adjustment Restated Assets Restated Liabilities % 1,142, , ,318 1,386, , % 1,046, , ,193 1,312, , % 1,028, , ,051 1,309, , % 1,022, , ,475 1,310, , % 1,092, , ,899 1,388, , % 1,124, , ,645 1,431, ,406 The restatement shows that the assets and liabilities increase by the capitalization of the leases. This adjustment corrects the overstatement of the assets that was created by filing the leases as an operating lease. Below we will show the as stated and restated balance sheets along with the depreciation table (All numbers presented in thousands). 60 P a g e

61 CHEESECAKE FACTORY INC 10-K Balance Sheet ASSETS Current assets: Cash and cash equivalents Investments and marketable securities Accounts receivable Income tax receivable Other receivables Inventories Prepaid expenses Deferred income taxes As stated December 30, 2008 $80, ,537 12,713 32,821 23,132 24,654 3,001 dr cr Restated December 30, 2008 $80, ,537 12,713 32,821 23,132 24,654 3,001 Total current assets 190, ,219 Property and equipment, net 860, ,489 OL Cap. Rights 244, ,318 Other assets: Marketable securities Trademarks Prepaid rent Other Total other assets Total assets 4,177 58,323 29,422 91,922 $1,142,630 4,177 58,323 29,422 91,922 $1,386,948 LIABILITIES AND STOCKHOLDERS EQUITY Current liabilities: Accounts payable Income taxes payable Other accrued expenses Total current liabilities $37, , ,833 $37, , ,833 Deferred income taxes Deferred rent Deemed landlord financing liability Long-term debt Other noncurrent liabilities 87,045 57,286 54, ,000 30,013 87,045 57,286 54, ,000 30,013 OL Cap. Liabilities 244, ,318 Total Liabilities 690, ,382 Commitments and contingencies Stockholders equity: Preferred stock, $.01 par value, 5,000,000 shares authorized; none issued Junior participating cumulative preferred stock, $.01 par value, 150,000 shares authorized; none issued Common stock, $.01 par value, 250,000,000 shares authorized; 82,846,857 and 82,660,209 shares issued at December 30, 2008 and January 1, 2008, respectively Additional paid-in capital Retained earnings Accumulated other comprehensive loss Treasury stock 23,100,079 and 13,508,424 shares at cost at December 30, 2008 and January 1, 2008, respectively , ,711 (9,684) (506,208) , ,711 (9,684) (506,208) Total stockholders equity Total liabilities and stockholders equity 452,566 $1,142, ,566 $1,386, P a g e

62 CHEESECAKE FACTORY INC 10-K Balance Sheet ASSETS Current assets: Cash and cash equivalents Investments and marketable securities Accounts receivable Income tax receivable Other receivables Inventories Prepaid expenses Deferred income taxes As Stated December 29, 2009 $73,715 11,352 1,875 27,475 22,202 27,871 7,737 dr cr Restated December 29, 2009 $73,715 11,352 1,875 27,475 22,202 27,871 7,737 Total current assets 172, ,227 Property and equipment, net 788, ,402 OL Cap. Rights 266, ,193 Other assets: Trademarks Prepaid rent Other Total other assets Total assets 4,338 54,243 27,541 86,122 $1,046,751 4,338 54,243 27,541 86,122 $1,312,944 LIABILITIES AND STOCKHOLDERS EQUITY Current liabilities: Accounts payable Other accrued expenses Total current liabilities $33, , ,461 $33, , ,461 Deferred income taxes Deferred rent Deemed landlord financing liability Long-term debt 87,048 64,209 51, ,000 87,048 64,209 51, ,000 OL Cap. Liabilities 266, ,193 Other noncurrent liabilities 27,118 27,118 Total Liabilities 530, ,831 Commitments and contingencies Stockholders equity: Preferred stock, $.01 par value, 5,000,000 shares authorized; none issued Junior participating cumulative preferred stock, $.01 par value, 150,000 shares authorized; none issued Common stock, $.01 par value, 250,000,000 shares authorized; 83,377,092 and 82,846,857 shares issued at December 29, 2009 and December 30, 2008, respectively Additional paid-in capital Retained earnings Accumulated other comprehensive loss Treasury stock 23,100,079 shares at cost at December 29, 2009 and December 30, , ,544 (4,619) (506,208) , ,544 (4,619) (506,208) Total stockholders equity Total liabilities and stockholders equity 516,113 $1,046, ,113 $1,312, P a g e

63 CHEESECAKE FACTORY INC 10-K Balance Sheet ASSETS Current assets: Cash and cash equivalents Investments and marketable securities Accounts receivable Income tax receivable Other receivables Inventories Prepaid expenses Deferred income taxes As Stated December 29, 2009 $73,715 11,352 1,875 27,475 22,202 27,871 7,737 dr cr Restated December 29, 2009 $73,715 11,352 1,875 27,475 22,202 27,871 7,737 Total current assets 172, ,227 Property and equipment, net 788, ,402 OL Cap. Rights 266, ,193 Other assets: Trademarks Prepaid rent Other Total other assets Total assets 4,338 54,243 27,541 86,122 $1,046,751 4,338 54,243 27,541 86,122 $1,312,944 LIABILITIES AND STOCKHOLDERS EQUITY Current liabilities: Accounts payable Other accrued expenses Total current liabilities $33, , ,461 $33, , ,461 Deferred income taxes Deferred rent Deemed landlord financing liability Long-term debt 87,048 64,209 51, ,000 87,048 64,209 51, ,000 OL Cap. Liabilities 266, ,193 Other noncurrent liabilities 27,118 27,118 Total Liabilities 530, ,831 Commitments and contingencies Stockholders equity: Preferred stock, $.01 par value, 5,000,000 shares authorized; none issued Junior participating cumulative preferred stock, $.01 par value, 150,000 shares authorized; none issued Common stock, $.01 par value, 250,000,000 shares authorized; 83,377,092 and 82,846,857 shares issued at December 29, 2009 and December 30, 2008, respectively Additional paid-in capital Retained earnings Accumulated other comprehensive loss Treasury stock 23,100,079 shares at cost at December 29, 2009 and December 30, , ,544 (4,619) (506,208) , ,544 (4,619) (506,208) Total stockholders equity Total liabilities and stockholders equity 516,113 $1,046, ,113 $1,312, P a g e

64 CHEESECAKE FACTORY INC 10-K Balance Sheet ASSETS Current assets: Cash and cash equivalents Accounts receivable Income tax receivable Other receivables Inventories Prepaid expenses Deferred income taxes As stated December 28, 2010 $81,619 16,184 3,840 27,296 23,036 28,345 5,732 dr cr Restated December 28, 2010 $81,619 16,184 3,840 27,296 23,036 28,345 5,732 Total current assets 186, ,052 Property and equipment, net 755, ,468 OL Cap. Rights 281, ,051 Other assets: Trademarks Prepaid rent Other Total other assets Total assets 4,498 50,391 31,988 86,877 $1,028,397 4,498 50,391 31,988 86,877 $1,309,448 LIABILITIES AND STOCKHOLDERS EQUITY Current liabilities: Accounts payable Other accrued expenses Total current liabilities $32, , ,705 $32, , ,705 Deferred income taxes Deferred rent Deemed landlord financing liability Long-term debt Other noncurrent liabilities Commitments and contingencies 86,918 67,258 51,954 27,225 86,918 67,258 51,954 27,225 OL Cap. Liabilities 281, ,051 Total Liabilities 436, ,111 Stockholders equity: Preferred stock, $.01 par value, 5,000,000 shares authorized; none issued Junior participating cumulative preferred stock, $.01 par value, 150,000 shares authorized; none issued Common stock, $.01 par value, 250,000,000 shares authorized; 84,912,101 and 83,377,092 shares issued at December 28, 2010 and December 29, 2009, respectively Additional paid-in capital Retained earnings Accumulated other comprehensive loss Treasury stock 25,204,104 and 23,100,079 shares at cost at December 28, 2010 and December 29, 2009, respectively , ,257 (558,296) , ,257 (558,296) Total stockholders equity Total liabilities and stockholders equity 592,337 $1,028, ,337 $1,309, P a g e

65 CHEESECAKE FACTORY INC 10-K Balance Sheet ASSETS Current assets: Cash and cash equivalents Accounts receivable Income tax receivable Other receivables Inventories Prepaid expenses Deferred income taxes As stated January 3, 2012 $48,211 11,334 5,472 32,096 28,210 36,498 14,574 dr cr As stated January 3, 2012 $48,211 11,334 5,472 32,096 28,210 36,498 14,574 Total current assets 176, ,395 Property and equipment, net 758, ,503 OL Cap. Rights 287, ,475 Other assets: Intangible assets, net Prepaid rent Other Total other assets Total assets 14,674 49,490 23,508 87,672 $1,022,570 14,674 49,490 23,508 87,672 $1,310,045 LIABILITIES AND STOCKHOLDERS EQUITY Current liabilities: Accounts payable Other accrued expenses Total current liabilities $36, , ,240 $36, , ,240 Deferred income taxes Deferred rent Deemed landlord financing liability Other noncurrent liabilities Commitments and contingencies 103,927 69,742 55,086 27, ,927 69,742 55,086 27,822 OL Cap. Liabilities 287, ,475 Total Liabilities 479, ,292 Stockholders equity: Preferred stock, $.01 par value, 5,000,000 shares authorized; none issued Junior participating cumulative preferred stock, $.01 par value, 150,000 shares authorized; none issued Common stock, $.01 par value, 250,000,000 shares authorized; 85,863,313 and 84,912,101 shares issued at January 3, 2012 and December 28, 2010, respectively Additional paid-in capital Retained earnings Treasury stock 31,196,128 and 25,204,104 shares at cost at January 3, 2012 and December 28, 2010, respectively Total stockholders equity Total liabilities and stockholders equity , ,977 (730,422) 542,753 $1,022, , ,977 (730,422) 542,753 $1,310, P a g e

66 CHEESECAKE FACTORY INC 10-K Balance Sheet ASSETS Current assets: Cash and cash equivalents Accounts receivable Income tax receivable Other receivables Inventories Prepaid expenses Deferred income taxes As stated January 1, 2013 $83,569 14,558 48,100 28,836 39,887 15,257 dr cr Restated January 1, 2013 $83,569 14,558 48,100 28,836 39,887 15,257 Total current assets 230, ,207 Property and equipment, net 764, ,418 OL Cap. Rights 295, ,899 Other assets: Intangible assets, net Prepaid rent Other Total other assets Total assets 17,829 50,793 28,920 97,542 $1,092,167 17,829 50,793 28,920 97,542 $1,388,066 LIABILITIES AND STOCKHOLDERS EQUITY Current liabilities: Accounts payable Income tax payable Other accrued expenses Total current liabilities $46,998 1, , ,034 $46,998 1, , ,034 Deferred income taxes Deferred rent Deemed landlord financing liability Other noncurrent liabilities Commitments and contingencies 91,852 76,144 55,123 36,288 91,852 76,144 55,123 36,288 OL Cap. Liabilities 295, ,899 Total Liabilities 512, ,340 Stockholders equity: Preferred stock, $.01 par value, 5,000,000 shares authorized; none issued Junior participating cumulative preferred stock, $.01 par value, 150,000 shares authorized; none issued Common stock, $.01 par value, 250,000,000 shares authorized; 87,812,022 and 85,863,313 shares issued at January 1, 2013 and January 3, 2012, respectively Additional paid-in capital Retained earnings Treasury stock 34,414,222 and 31,196,128 shares at cost at January 1, 2013 and January 3, 2012, respectively , ,532 (831,814) , ,532 (831,814) Total stockholders equity 579, ,726 Total liabilities and stockholders equity $1,092, P a g e $1,388,066

67 CHEESECAKE FACTORY INC 10-K Balance Sheet ASSETS Current assets: Cash and cash equivalents Accounts receivable Income tax receivable Other receivables Inventories Prepaid expenses Deferred income taxes As stated December 31, 2013 $61,751 10,081 4,529 55,461 35,478 42,595 16,008 dr cr Restated December 31, 2013 $61,751 10,081 4,529 55,461 35,478 42,595 16,008 Total current assets 225, ,903 Property and equipment, net 795, ,379 OL Cap. Rights 307, ,645 Other assets: Intangible assets, net Prepaid rent Other Total other assets Total assets 18,647 47,064 37, ,832 $1,124,114 18,647 47,064 37, ,832 $1,431,759 LIABILITIES AND STOCKHOLDERS EQUITY Current liabilities: Accounts payable Income tax payable Other accrued expenses Total current liabilities $35, , ,247 $35, , ,247 Deferred income taxes Deferred rent Deemed landlord financing liability Other noncurrent liabilities Commitments and contingencies 97,237 74,690 66,197 44,390 97,237 74,690 66,197 44,390 OL Cap. Liabilities 307, ,645 Total Liabilities 546, ,406 Stockholders equity: Preferred stock, $.01 par value, 5,000,000 shares authorized; none issued Junior participating cumulative preferred stock, $.01 par value, 150,000 shares authorized; none issued Common stock, $.01 par value, 250,000,000 shares authorized; 90,632,325 and 87,812,022 shares issued at December 31, 2013 and January 1, 2013, respectively Additional paid-in capital Retained earnings Treasury stock 38,865,951 and 34,414,222 shares at cost at December 31, 2013 and January 1, 2013, respectively , ,451 (1,015,473) , ,451 (1,015,473) Total stockholders equity Total liabilities and stockholders equity 577,353 $1,124, ,353 $1,431, P a g e

68 Depreciation Table Rate: BB Int. Pmt. EB Depreciation Rate: BB Int. Pmt. EB Depreciation Rate: BB Int. Pmt. EB Depreciation Rate: BB Int. Pmt. EB Depreciation Rate: BB Int. Pmt. EB Depreciation Rate: BB Int. Pmt. EB Depreciation P a g e

69 The balance sheets show further what we saw with the restatement table. The assets are overstated due to the lump sum of prepaid rent. After capitalization of the operating leases we show an increase in assets and liabilities by $244,318, $266,193, $281,051, $287,475, $295,899, and $307,844 (In thousands). This is a very large increase in both accounts that would have otherwise not been recognized if there was not capitalization of the leases. This restatement changes our view of the company pretty substantially because the lack of disclosure on top of the massive capitalization expenditures was eyeopening. Fortunately, this was the only distortion on the financials. Financial Analysis Liquidity Ratios Liquidity is the measure of how quickly assets can be turned into cash. On the balance sheet the accounts are put in order of liquidity starting with cash. The ratios we have analyzed for the liquidity of The Cheesecake Factory and the industry are the current ratio, quick ratio, inventory turnover, inventory days, accounts receivable turnover, accounts receivable days, cash to cash ratio, and the working capital turnover. We analyze the liquidity of a company to see how easily a company can pay its bills. Unhealthy liquidity ratios can be a signal of an inability to pay debt and means a higher risk for investors and possibly bankruptcy for the company. 69 P a g e

70 Current Ratio The current ratio is derived from dividing the firm s current assets by the current liabilities. This ratio tells how easily a company can pay off its short term debt with its short term assets. When analyzing the current ratio we look for a number above 1.0 as that shows that for every $1 of debt the company has $1 of assets to cover the debt with. Anything below 1.0 indicates an unhealthy current ratio and the company should attempt to raise the ratio by utilizing less short term debt or increasing highly liquid assets such as cash and receivables. The table below shows that The Cheesecake Factory and the industry as a whole has a very unhealthy current ratio. The industry is starting to move towards a yearly current ratio of around 0.65 which indicates for every dollar of short term debt the industry has $0.65 to pay it off with. It is likely that the low current ratio is a result of very low receivables for the industry which we will look into more detail when we analyze the accounts receivable turnover and days ratios. The industry also has a large majority of the assets wrapped up in PPE because the industry grows through opening new restaurants and PPE is not considered a current asset. Date CAKE Brinker Darden BJ s P a g e

71 CAKE BJ's Brinker Darden Quick Ratio The quick ratio is an even better determinant of the liquidity of a company than the current ratio because it does not include inventory in the calculation. We derive the quick ratio by subtracting inventory from current assets and then dividing by current liabilities. Even though inventory is taken from the ratio we still want to see a ratio of 1.0. From the table below we see that the industry is still quite low and relatively unhealthy for the quick ratio. This is also likely attributed to very low receivables across the industry which we will look into in more detail with the accounts receivable turnover and days ratios. The overall poor performance with the current ratio set up the quick ratio for poor results for all the same reasons as what went wrong with the current ratio. The industry performed better than expected, however, because inventory is not a major portion of the assets. Even though CAKE exceeded our expectations the average quick ratio is.72 which means they can only pay off $0.72 for every dollar of 71 P a g e

72 current debt. This still signals an unhealthy ratio that could mean CAKE cannot pay off its debt and would be a more risky investment. Date CAKE Brinker Darden BJ s CAKE Brinker Darden BJ's Inventory Turnover Inventory turnover shows how many times per year inventory is replaced and is derived by dividing net sales by inventory. When analyzing inventory turnover a higher inventory turnover ratio is much better than a lower turnover number because it indicated a good rate of sales due to inventory needing to be 72 P a g e

73 replaced more often. Here we see where the industry really shines. Every company in the industry except for Darden has a very high inventory turnover rate. This can be attributed to two different causes. The first is very high sales resulting in a need to replace inventory often. The second is that the inventory of the industry is made up primarily of perishable goods, therefore the companies in the industry must replace inventory more often. The companies in the industry generally buy smaller amounts of inventory and restock at a much higher rate because the goods are perishable and the companies do not want to waste money on inventory for it to perish. This is a case of less is more in that buying a smaller inventory and selling the great majority of it is better than buying a large number of inventory and not selling all of it resulting in wasted money and wasted inventory. The industry is clearly segmented with Brinker and BJ s turning over inventory over 100 times a period, CAKE in the middle turning over on average about 65 times per period, and Darden only turning over about 28 times per period. The segmentation can show the front runners in the industry compared to the companies that are beginning to lag behind because a larger inventory turnover can mean a larger volume of sales. Volume of sales is not the only indicator of high turnover though because, as stated above, the lesser companies can be simply buying larger portions of inventory and needing to restock less than the front runners who could be buying smaller portions of inventory and turning over more often to restock. Date CAKE Brinker Darden BJ s P a g e

74 CAKE Brinker Darden BJ's Inventory Days Inventory days outstanding is directly related to inventory turnover and is derived by taking the number of days in the period and dividing that number by inventory turnover. The period for the industry is 365. Inventory days outstanding is another way to look at how many times inventory is replaced per period because it shows how many days it takes on average for a company to replace inventory. When analyzing inventory days outstanding we are looking for a low number and are comparing to the industry. As with inventory turnover the industry performs very well with inventory days outstanding. The numbers across the industry are very low with the exception of Darden. The Cheesecake Factory performs very well, replacing their inventory about once every week. This number can be attributed to the same causes that affected inventory turnover, Perishable inventory and high sales volume. Looking at inventory days outstanding we noticed the industry segmentation closed up drastically between 74 P a g e

75 CAKE and the two frontrunners from inventory turnover. This tells us that CAKE utilizes similar inventory practices with Brinker and BJ s because CAKE s inventory is only outstanding for about 2-3 more days than theirs. The decrease in segmentation between days outstanding and inventory turnover showed that CAKE was still with the frontrunners of the industry and was not just middle of the pack. Date CAKE Brinker Darden BJ s CAKE Brinker Darden BJ's P a g e

76 Accounts Receivable Turnover Accounts receivable turnover is very similar to inventory turnover and is derived by dividing net sales by accounts receivable. As with inventory turnover this ratio shows how many times per period accounts receivables are collected. When analyzing accounts receivable turnover, we are looking for a higher number and are comparing CAKE to the rest of the industry. In the table and graph below we see that the industry as a whole has relatively high turnover for receivables. The Cheesecake Factory leads the industry in this category, but is not too far ahead of the industry. The reason the industry has large accounts receivable turnover rates are because the industry requires the vast majority of the revenues to be paid for on the spot which results in a very low number of receivables. The majority of those receivables are included in gift cards which are generally used within a week or two which attributes to the high turnover as well. Because the industry does not have much in the way of accounts receivable and it is such a small amount of total assets this metric does not hold much weight in the valuation of The Cheesecake Factory, however, the numbers for the turnover are very encouraging and show that CAKE does not allow receivables to stay outstanding for very long. Date CAKE Brinker Darden BJ s P a g e

77 CAKE Brinker Darden BJ's Accounts Receivable Days Like with inventory days, accounts receivable days shows how many days the receivables are generally outstanding before being collected. It is derived from taking the number of days in the period (365 for the industry) and dividing by the accounts receivable turnover. When analyzing accounts receivable days outstanding a lower number is more desirable and we will also be comparing CAKE to the industry. Since accounts receivable days is directly related to inventory turnover it is no surprise that the Cheesecake Factory leads the way in this category as well. They only have their receivables outstanding for about 2.5 days at a time which is a very fast rate of collecting receivables. The almost immediate collection of receivables shows that the receivables for The Cheesecake Factory are very liquid in that they are turned to cash in about 2-3 days. As stated above, this low accounts receivable days outstanding rate is 77 P a g e

78 caused by a lack of sales that go on credit and a quick gift card turnover which is the main component of accounts receivable. Date CAKE Brinker Darden BJ s CAKE Brinker Darden BJ's Cash to Cash The cash to cash cycle shows how quickly a company can turn its resources into cash through sales. A smaller number is more desirable but we are also comparing The Cheesecake Factory to the rest of the industry. The industry as a whole stays on a relatively same level with only Darden being the major outlier. The industry performs well too with only about 9 days between 78 P a g e

79 obtaining a resource and turning it into cash and that number of days is trending down as well showing a healthy trend. This ratio is a great tool to determine liquidity as it relates to all resources instead of just how quickly specific items are turned into cash. The low rates of just about 9 days for the Cheesecake Factory show that the company is quick about turning resources to cash and is also not very far off from the rest of the industry. This quick turnover relates to the strategies discussed in the inventory turnover and the accounts receivable turnover. Quick turnover of inventory and low amounts of accounts receivable allow for a quick cash turnover of resources. Date CAKE Brinker Darden BJ s CAKE Brinker Darden BJ's P a g e

80 Working Capital Turnover Working capital turnover shows how effectively the company uses its working capital to create sales. This is another ratio that does not have a specific number we want to see and are using this number as a comparison to the rest of the industry, but generally higher is better. Unfortunately the entire industry suffers from very low working capital turnover. This is likely attributed to the fact that there is a low amount of current assets throughout the industry which creates negative working capital and combined with the high volume of sales creates large, negative working capital turnover. What this tells us is that current assets and liabilities are not used effectively in turning in sales. The companies in the industry use a large amount of non current assets and liabilities to create wealth in the companies. In terms of liquidity there is not much to be said of the working capital turnover ratio other than it provides very little value for the companies in the industry. Date CAKE Brinker Darden BJ s P a g e

81 CAKE Brinker Darden BJ's Conclusion After analyzing the liquidity ratios of The Cheesecake Factory and the industry we see that generally the industry suffers from very unhealthy ratios, with the only healthy ratios being inventory and receivables turnover and days. The other ratios are very low and that shows a higher level of risk for the companies in the industry and investors. The industry as a whole needs to utilize more current assets instead of relying on equity and non-current assets to provide the majority of the value in the companies. An increase in receivable acceptance and resource management can assist in getting the current assets up and ultimately increasing the liquidity of the industry. 81 P a g e

82 Profitability Ratios The profitability ratios show how well a company retains revenues after deducting expenses starting with gross profit and going all the way to net income. As with the liquidity ratios we want to mainly compare to the industry but generally higher will be better with these ratios. We will be analyzing the sales growth, gross profit margin, operating profit margin, net profit margin, asset turnover, return on assets, and return on equity. Sales Growth The sales growth method shows the percent increase in sales from year to year. It is derived with the following equation: (New sales-prior year sales)/prior year sales. The higher the growth the better because it shows a larger increase in sales from year to year, but we will be focusing primarily on comparing The Cheesecake Factory to the industry and seeing where the company stacks up to the competitors. The industry as a whole fluctuates pretty largely on a year to year basis for the sales growth, but are all moving towards a steady growth rate of about 6% per year. Cheesecake Factory has been steadily growing by about 4% per year since The abnormally low growth rates across 2009 can be attributed to the economic crash in Stable growth in sales is always a good trend even if the growth is only a small percentage. The sales growth is smaller in this industry because the companies do not achieve growth by way of increasing sales per store but by opening new restaurants and expanding that way. Therefore, the value of the companies that can be attributed to the sales growth is nice and consistent but is not the main way the industry expands. 82 P a g e

83 Date CAKE NA -.27% 3.58% 5.92% 2.92% 3.81% Brinker NA % % -4.22% 2.35% 0.66% Darden NA 8.92% -1.45% 5.44% 6.65% 6.92% BJ s NA 14.07% 20.42% 20.84% 14.07% 9.43% CAKE Brinker Darden BJ's Gross Profit Margin Gross profit margin shows how much money a company retains after cost of sales is taken into account. It is calculated by dividing gross profit by revenue. A higher number is better as it shows more retention of money after the initial costs are deducted from sales. The industry is extremely consistent with the gross profit margin. The Cheesecake Factory has a good gross profit margin and retains about $0.75 of every $1 of revenue they obtain as it pertains 83 P a g e

84 to the gross profit. The industry does not fluctuate much from that number either averaging about $0.72 per dollar. The Cheesecake Factory s retention of profits after cost of goods is promising but can be attributed to the fact that the company serves fresh food daily and the only expense that goes into the cost of the food is how much it cost the company to purchase it. Since the industry is upscale casual there is an understanding that the companies in the industry are going to charge substantially more for the product than it cost them to obtain it. Because of this the expenses are going to come on later with the operating expenses and income taxes. Date Cake Brinker Darden BJ s CAKE Brinker Darden BJ's P a g e

85 Operating Profit Margin The operating profit margin is like the gross profit margin but the expenses up to operating income are being taken out of revenues. Like gross profit margin the higher the better but we are also comparing The Cheesecake Factory to the industry. There is a significant drop off in retention with this profit margin mainly because there are a large number of expenses that have now been taken out of revenue. The expenses mainly include depreciation and amortization but there is a huge expense in labor. The labor expense is actually more expensive than the costs of goods with labor expense totaling $533,080 and cost of goods totaling $416,000 in 2008 (CAKE 10-K). Those numbers do not fluctuate far from that with the difference in labor expense to cost of goods staying around $120,000-$150,000. The industry is still very consistent as a whole when it comes to this ratio. The Cheesecake Factory averages about $0.08 per dollar retention by the operating profit margin. Compared to the industry that is a really good retention rate and shows a healthy operating profit margin. Even then, the massive increase in expenses between gross profit and operating income is a concern and the companies should attempt to cut down on those expenses by lowering wages slightly and finding a way to lower the costs of operation to manageable numbers. By decreasing expenses, the industry can achieve a higher retention rate and not experience such a dramatic decrease in retention between gross profit and operating income. 85 P a g e

86 Date CAKE Brinker Darden BJ s CAKE Brinker Darden BJ's Net Profit Margin The net profit margin is the same as the previous two margins except it is using net income divided by revenues instead of gross profit or operating income. Also like the previous two margins higher is better but we are also looking at comparison with the rest of the industry as well. The numbers decrease further due to the last of the expenses being taken out of revenues, but there are significantly fewer expenses than with operating income. The numbers for net profit margin stay consistent with the previous margins that the 86 P a g e

87 industry is very consistent and the Cheesecake Factory has a healthy net profit margin. Even though The Cheesecake Factory stays ahead of the competition again with this ratio, retention of around 5 cents for every dollar earned is pretty eye opening. The expenses incurred after operating income is very manageable but the ratio suffers from the extreme amount of expenses incurred before operating income. There is almost no separation at this point between the industry with CAKE and Brinker leading the way retaining $0.06 for every dollar and BJ s trailing with a retention rate of $0.03 for every dollar. The lack of separation shows just how consistent and competitive the industry is, making every cent retained count. CAKE appears more stable than the competition by leading in retention after net profit margin, leading to an increase in overall value compared to the competition. Date CAKE Brinker Darden BJ s CAKE Brinker Darden BJ's P a g e

88 Asset Turnover Asset turnover ratio deduces the amount of sales per dollar of total assets. This is another ratio where higher is better but we are also comparing the Cheesecake Factory to the industry. The asset turnover ratios for the industry are very consistent and very healthy. The Cheesecake Factory produces an average of $1.50 for every dollar of assets. That number is desirable and achieves a healthy asset turnover ratio. The industry stays consistent with the Cheesecake Factory and maintains a healthy asset turnover ratio overall. Generating a $1.50 in sales per every dollar in assets is great and provides a large amount of stability since they are producing more than it cost to obtain the assets. This metric shows how important plant, property, and equipment is to these companies. As we saw when analyzing current ratio and quick ratio, there are very few readily convertible assets on the books of these companies and provide little value. PP&E creates the majority of the assets on the books because the industry expands and grows by way of opening more restaurants. Because asset turnover takes PP&E into account we now see the true value of the assets of these companies, especially PP&E. Date CAKE Rested Brinker Darden BJ s P a g e

89 CAKE Restated Brinker Darden BJ's Return on Assets Return on Assets evaluates how efficient a company is at making profits with the assets used. It is derived by dividing net income by total assets and is shown as a percentage. The higher the number the better off the company is. The table below shows that the Cheesecake Factory and the industry as a whole do not get a very large return on assets with the Cheesecake Factory topping out at 10%. Unfortunately the massive expenses taken out of revenues greatly reduce the return on assets. There will be a larger return on assets if the companies reduce expenses that get taken out of revenue. As pointed out in the operating margin, there is an extreme expenditure in labor expense and other operating expense that make up over half of the total expenses before operating income. If these expenses can get reduced, either through wage cuts or improvements in operating efficiency, then many of the profitability ratios will 89 P a g e

90 increase dramatically which will add substantial value to The Cheesecake Factory and really separate it from the competition. Date CAKE 4.58% 4.09% 7.95% 9.36% 9.01% 10.17% Restated 3.99% 3.27% 5.89% 6.69% 7.89% 7.99% Brinker 2.36% 4.06% 7.44% 9.50% 10.51% 11.25% Darden 7.97% 7.41% 7.67% 8.71% 8.00% 5.94% BJ s 3.08% 3.42% 5.39% 6.29% 5.61% 3.44% CAKE Restated Brinker Darden BJ's Return on Equity Like with return on assets, the return on equity shows how efficient the company is at creating sales with equity. The higher the number the better but too high of a number can show too much reliance on equity to create income. It is derived by dividing net income by total shareholder equity. The industry has 90 P a g e

91 much healthier numbers for the return on equity than the return on assets which shows a higher reliance on equity to provide income. The Cheesecake Factory tops out at 20% which is 10% higher than the maximum reached with return on assets. The industry does a good job of staying at a healthy level of return on equity with the only exception being Brinker relying too heavily on equity to provide income. The reliance on equity has been mentioned throughout the analysis and is showing here with almost double a return on equity than assets. We do not see an over reliance on the equity, however, and the ratio is a good indicator of value of equity to the company. Date CAKE 11.55% 8.30% 13.80% 17.64% 16.98% 19.81% Brinker 8.69% 12.24% 18.90% 32.14% 48.80% % Darden 26.77% 23.18% 20.89% 25.15% 25.81% 20.00% BJ s 4.44% 5.15% 8.08% 9.50% 8.54% 5.24% CAKE Brinker Darden BJ's P a g e

92 Conclusion The profitability ratios were much healthier than the liquidity ratios since almost every ratio had positive, healthy results. The Cheesecake Factory looks more stable after analysis of the profitability ratios than it did post-liquidity analysis. These ratios show that the Cheesecake Factory along with the industry are healthy when it comes to looking at how they obtain and maintain income. The Cheesecake Factory stayed that the top of the competition for the majority of the profitability ratios and if the company can delete some of the expenses incurred with labor costs and other operating expenses the company could set themselves apart from the competition and increase overall company value dramatically. Capital Structure Ratios When valuing a firm, analyzing the capital structure ratios is a vital step. Analyzing capital structure ratios can reveal how a company has been spending its money as well as where it is derived from. By analyzing the right ratios, it will be apparent how the company has been dealing with its stockholders equity, and debt. In short, capital structure ratios measure a company s ability to meet its obligations and how much of the company s assets are being financed with debt. 92 P a g e

93 Debt to Equity Ratio The debt to equity ratio shows how much of the company s financing has come from outside sources like a creditor or an investor. This ratio is found by dividing the total debt, or liabilities, by the total stockholders equity. So therefore, the higher the ratio represents a high amount of debt to equity. In that case, a ratio around one shows a balance between the company s debt and equity. The table shows that CAKE has a higher debt to equity ratio than its competitors which shows a higher reliance on debt to finance the company s assets CAKE CAKE Restated Brinker Darden BJ s P a g e

94 Cake Cake Restated Brinker Darden BJ's The Cheesecake Factory, prior to restatement has a debt to equity ratio of.95. This shows that the company s assets are being funded more so by investors than creditors. After restating the financial statements, this is no longer the case. Cheesecake Factory s restated debt to equity ratio is This is unfavorable to creditors because it shows that the creditors are pumping in more money to the Cheesecake Factory to finance their assets than the investors are. Times Interest Earned The times interest earned ratio is used to determine if a company can fulfill its debt obligations. This ratio indicates how many times a company can cover its interest charges with its income on a pretax basis. This is a particularly important benchmark because this is one of the earlier signs of a firm headed towards bankruptcy. The times interest earned ratio can be found by taking income before interest and taxes, and dividing it by the interest expense. Any 94 P a g e

95 value below one would be seen as a risk not worth taking for the investors. Since 2008, the Cheesecake Factory and its competition have had a steady increase to their times interest earned ratio. The only hiccup comes from Darden as its ratio dropped over 2 points in the span of a year. That being said, Darden is still well within the safe zone for now. BJ s Brewhouse was left out because they are debt free. The same can be said for the Cheesecake Factory as of CAKE Brinker Darden Cake Restated Brinker Darden Note that starting in 2011 and continuing on through 2012 and 2013, the Cheesecake Factory had a times interest earned ratio that was exceedingly high. 95 P a g e

96 This means that the Cheesecake Factory had enough income to pay off their interest expense several times over, boding well for them. Altman s Z-Score Altman s Z-Score is made up of five different performance judging formulas and then added together to get one score. When the overall score is assessed and analyzed, it can determine the likeliness of a firm headed towards bankruptcy. Altman came up with guidelines to remember when analyzing the z- score. They are as follows: If a firm has a z-score greater than 3, then it is in no danger of bankruptcy If a firm has a score between 3-1.8, this is considered a gray area If a firm s z-score is lower than 1.8 then it is headed for bankruptcy The Cheesecake Factory and nearly all of its competition have no reason to worry about falling into the danger zone. However, for Darden, their z-score has been slightly declining since Darden must find a way to turn this ship around before they fall out of the gray area and are considered as nearing bankruptcy. 96 P a g e

97 CAKE Cake Restated Brinker Darden BJ s Cake Cake Restated Brinker Darden BJ's As stated before the benchmark Z-score is anything above a After 2008, the Cheesecake Factory has consistently stayed above the 3.00 safe zone. Cheesecake Factory has shown no signs of worry as they have had a steady increase of Z-scores in the past 5 years. 97 P a g e

98 Financial Forecasting In order for us to value a firm there must be financial forecasting. When forecasting financial statements it is important that we make well educated assumptions using historical ratios, trends, industry patterns, as well as taking into account the current economic situations. By using these methods of valuation we, the financial analysts, will be able to define the intrinsic value of a firm based upon our assumptions. However, it is important to keep in mind that the longer a period is forecasted out the less reliable the estimates become. In order to forecast out the next 10 years of financial information we will use the income statement, balance sheet, and statement of cash flows of The Cheesecake Factory Inc. and a series of ratios that allow us to make our assumptions. Income Statement In order to be able to forecast the balance sheet and statement of cash flows, the first step we will take is examining is the income statement. The income statement must use logical assumptions due to these numbers being used later in the balance sheet and statement of cash flows. In general, the most important factor used in forecasting the income statement is the sales growth percentage. Current economic situations must be taken into account when estimating sales growth along with historical sales figures as well. The future revenues forecasted in this section will be used in multiple liquidity and profitability ratios used to forecast the balance sheet and statement of cash flows. Because the current economic situation is not as severe as it was in the recession of 2008, with economies failing and then slowly recovering, we used an average estimate of sales growth over the past 5 years in order to signify the 98 P a g e

99 currently stabilizing economy. Over the past 5 years The Cheesecake Factory has shown a relatively consistent sales growth trend, with sales either going up or down a few percentage points between periods. We computed the average by calculating the sales growth between 2009 and 2013 and then averaging the numbers together. We decided to assume the average of 3.0% sales growth rate experienced between 2009 and 2013 in order to forecast the next 10 years of revenues. We are assuming the average based on the trend of growth in sales between the periods being relatively consistent from year to year, with years having relatively similar growth rates. Every year will increase by 3.0% due to the current economic situation being more stable than in This will lead to an aggregate increase in sales growth by 30% over the next 10 years. This aggregate growth is on par for the aggregate growth experienced between the years of 2009 and The aggregate growth over the five year period was 15.96%. After the percentage of sales growth is forecasted for the next 10 years a common sized income statement can be created. A common size income statement is used to report each factor in the income statement as a percentage of revenues. By using this method trends and patterns can be seen and forecasted relatively easily. We as financial analysts have decided to use an average gross profit margin in order to represent a stabilizing economy as well as the steady trend currently being experienced by The Cheesecake Factory Inc. in terms of gross profits. Gross profit has been steadily consistent in accordance to revenues, with gross profit being around 75% of revenues from years 2009 to In order to forecast out this consistent trend we took an average of the gross profit margin divided by revenues of the each period, resulting in an average gross profit relative to sales of 75.17%. By doing so we have also found an average for costs of goods sold, due to revenues subtracted from costs of goods sold equaling gross profit. The average of the costs of goods sold, 24.83%, is a product of the costs of goods sold for each period being around 25% consistently. 99 P a g e

100 The Cheesecake Factory Inc. has also been experiencing relative steadiness in accordance with its expenses. The only line item that experienced growth was Pre-Opening Expenses. However, the amount of pre-opening expenses to revenues is a relative non-factor when forecasting the income statement because although it experienced growth from 2009 to 2013, it only represents an average of 0.49% of total revenues. Expenses such as Other Operating Costs and Expenses as well as Labor are a key factor in forecasting out the income statements, averaging 24.51% and 32.36% of revenues, respectably. Both of these items experienced a steady percentage year to year in regards to revenues, with the percentages varying little if any. Therefore, we are using an average of the period s labor and operating costs and expenses data as a means to continue the trend the company is experiencing. The next important part of the common size income statement is the income from operations factor. The Cheesecake Factory experienced an increase in 2010 income from operations as compared to revenues from 2009 with income from operations being 4.60% of revenues to 7.73% of revenues in Between 2010 and 2012 the percentage was steady, varying only a decimal of a percentage point between 7.73%, 7.59%, and 7.67% respectably. In 2013 the percentage rose to 8.57%. In order to accurately forecast the income from operations we are going to use a slightly increasing percentage from 2013, accounting for a 0.05% increase in the first 2 years then leveling out the next 8. Because the percentage has experienced an increasing trend between 2011 and 2013, we are increasing the forecasted percentage slightly for the first two years and then leveling off as a means to maintain the steady growth that the company is trending in accordance with all other factors to the income statement. In doing so the forecasted income from operations rises from 8.57% in 2013 to 8.62% in 2014 and 8.67% in After 2015 we have leveled off with an average percentage of 8.67% for years 2016 to 2023, reflecting the steady trend that is present throughout the income statement. 100 P a g e

101 Along with forecasting income from operations we are also forecasting income before taxes. Income before taxes has experienced a growing trend between 2009 and Although the trend is increasing, it is not doing so by much. Due to the increasing trend we are forecasting income before income taxes as growing 0.5% from period to period. This steady increase is representative of the increase experienced between 2009 and 2013 in income before taxes and will rise from 8.83% in 2014 to 13.33% in The growth in income before taxes is aggressive due to the steadily increasing growth rate of total revenues. Net income is the last factor we forecasted in the income statement. Net income has experienced a growing trend at 2.67% of revenues in 2009 to 6.09% of revenues in For forecasting purposes we have forecasted net income as increasing from 6.34% in 2014 to 8.74% in The growth over the period is meant to be small in order to accurately forecast based upon previous historical data for net income. Once again, due to the forecasted period being 10 years, unexpected factors can affect our forecasted projections for the income statement. Using the forecasted numbers we are now able to forecast the balance sheet, statement of cash flows, and observe dividends. 101 P a g e

102 Income Statement As Stated Actual Financials Forecasted Financial Statements Assume Average Revenues $1,606,406 $1,602,020 $1,659,404 $1,757,624 $1,809,017 $1,877, % 100% $1,934, $1,992, $2,052, $2,113, $2,177, $2,242, $2,309, $2,378, $2,450, $2,523, $2,599, Cost of sales 416, , , , , , % $480, $494, $509, $524, $540, $556, $573, $590, $608, $626, GROSS PROFIT 1,189,605 1,207,611 1,246,549 1,309,156 1,358,864 1,422,225 75% $1,453, $1,497, $1,542, $1,588, $1,636, $1,685, $1,736, $1,788, $1,841, $1,897, Labor expenses 533, , , , , , % $625, $644, $664, $684, $704, $725, $747, $769, $792, $816, Other operating costs and expenses 397, , , , , , % $474, $488, $502, $517, $533, $549, $565, $582, $600, $618, General and administrative expense 83,731 97,432 95,729 96, , , % $112, $116, $119, $123, $127, $130, $134, $138, $143, $147, Depreciation and amortization expen 73,290 75,184 72,140 71,958 74,433 78, % $82, $85, $87, $90, $93, $96, $98, $101, $105, $108, Impairment of assets 2,952 26,541 1,547 9,536 (561) Preopening costs 11,883 3,282 5,153 10,138 12,289 12, % $ 9, $ 9, $ 10, $ 10, $ 10, $ 11, $ 11, $ 11, $ 12, $ 12, Total costs and expenses 1,519,235 1,528,303 1,531,193 1,624,174 1,670,318 1,716,956 Income from operations 87,171 73, , , , , % 7.23% $166, $172, $177, $183, $188, $194, $200, $206, $212, $218, Interest expense (14,788) (23,433) (16,808) (4,307) (4,725) (4,504) -0.64% ($12,463.09) ($12,836.98) ($13,222.09) ($13,618.75) ($14,027.31) ($14,448.13) ($14,881.58) ($15,328.02) ($15,787.87) ($16,261.50) Interest income 1, Other income/(expense), net (977) 651 (506) Income before income taxes 73,255 51, , , , , % $170, $185, $201, $218, $235, $254, $273, $293, $314, $336, Income tax provision 20,962 8,474 29,376 33,423 35,551 42, % $32, $33, $34, $35, $36, $37, $38, $40, $41, $42, Net income $52,293 $42,833 $81,713 $95,720 $98,423 $114, % $122, $131, $140, $149, $159, $170, $181, $192, $204, $220, Common Size Income Statement Forecasted Financial Statements Fiscal Year (Dollars in thousands, except per share and sales per square foot data) Aggregate SG Statement of Income Data: % Aggregate Sales Growth Percent % 3.582% 5.919% 2.924% 3.808% % 3.00% 3.00% 3.00% 3.00% 3.00% 3.00% 3.00% 3.00% 3.00% 3.00% 30.00% Net sales % % % % % 100% % % % % % % % % % % Cost of goods sold (1) 24.62% 24.88% 25.52% 24.88% 24.27% 24.83% 24.83% 24.83% 24.83% 24.83% 24.83% 24.83% 24.83% 24.83% 24.83% 24.83% Gross profit 75.38% 75.12% 74.48% 75.12% 75.73% 75.17% 75.17% 75.17% 75.17% 75.17% 75.17% 75.17% 75.17% 75.17% 75.17% 75.17% Selling, general and administrative expenses 6.08% 5.77% 5.48% 5.76% 6.11% 5.84% 5.84% 5.84% 5.84% 5.84% 5.84% 5.84% 5.84% 5.84% 5.84% 5.84% Pre-opening expenses 0.20% 0.31% 0.58% 0.68% 0.69% 0.49% 0.49% 0.49% 0.49% 0.49% 0.49% 0.49% 0.49% 0.49% 0.49% 0.49% Labor Expenses 32.99% 32.36% 32.28% 32.07% 32.11% 32.36% 32.36% 32.36% 32.36% 32.36% 32.36% 32.36% 32.36% 32.36% 32.36% 32.36% Other Operating Costs and Expenses 25.15% 24.61% 24.38% 24.30% 24.10% 24.51% 24.51% 24.51% 24.51% 24.51% 24.51% 24.51% 24.51% 24.51% 24.51% 24.51% Depreciation and Amortization Expenses 4.69% 4.35% 4.09% 4.11% 4.18% 4.29% 4.29% 4.29% 4.29% 4.29% 4.29% 4.29% 4.29% 4.29% 4.29% 4.29% Income from operations 4.60% 7.73% 7.59% 7.67% 8.57% % 7.23% 8.62% 8.67% 8.67% 8.67% 8.67% 8.67% 8.67% 8.67% 8.67% 8.67% (Gain) on sale / loss on write-down of non-cash investment (2) (3) Interest expense % % % % % -0.64% -0.64% -0.64% -0.64% -0.64% -0.64% -0.64% -0.64% -0.64% -0.64% -0.64% Other income Income before income taxes 3.20% 6.69% 7.35% 7.41% 8.33% % 8.83% 9.33% 9.83% 10.33% 10.83% 11.33% 11.83% 12.33% 12.83% 13.33% Provision for income taxes 0.53% 1.77% 1.90% 1.97% 2.24% 1.68% 1.68% 1.68% 1.68% 1.68% 1.68% 1.68% 1.68% 1.68% 1.68% 1.68% Net income 2.67% 4.92% 5.45% 5.44% 6.09% % 6.34% 6.59% 6.84% 7.09% 7.34% 7.59% 7.84% 8.09% 8.34% 8.74% 102 P a g e

103 Dividends Forecasting Future expectations of dividend growth and value are heavy variables when valuing a firm. The Cheesecake Factory Inc., announced on July 22 nd, 2013 that the Board increased the authorization to repurchase our common stock by 7.5 million shares to 48.5 million shares. Under this and all previous authorizations, we have cumulatively repurchased 38.9 million shares at a total cost of $1,015.5 million through December 31,2013, including 4.5 million shares of our common stock at a cost of $183.7 million during fiscal year 2013 (Cheesecake 10-K). When forecasting this trend we have data regarding the first quarter of In order to accurately forecast 2014 dividend payout we have total shares outstanding as of June 25 th, 2014 at 48,300,000. The first quarterly dividend of the year was priced at.14 cents per share. Based on a trend of The Cheesecake Factory increasing the share price by.02 cents every 4 quarters, we have assumed the dividend will increase to 0.16 cents per share for the next 3 quarters of After calculating the dividend payout for 2014 based upon our assumptions, we have observed similar statistics in terms of In 2013 the first quarter paid a dividend of.12 cents with the next 3 quarters paying.14 cents per share. In 2014 the first quarter dividend price per share is.14 cents, with the next 3 quarters increasing by.02 cents, identical to the increase seen in Due to the similarities in dividend payout structure, we have assumed a continuous dividend payout structure and have forecasted dividends paid out for the next ten years according to the table below. 103 P a g e

104 Shares outstanding Dividends Declared May 9th 0.14 Dividends Paid as of May 9th Paid/ Outstanding Calculations for next 3 quarters Assuming Shares outstanding Estimation of Dividends paestimation + 1st quarter Dividend per share: 2nd quarter rd quarter th quarter Thousands total dividends paid Calculations Assuming Similar Payouts Thousands total dividends paid Thousands total dividends paid Thousands total dividends paid Thousands total dividends paid Thousands total dividends paid Thousands total dividends paid Thousands total dividends paid Thousands total dividends paid Thousands total dividends paid P a g e

105 Balance Sheet The next step in the forecasting process for valuation is to forecast the balance sheet now that we have the income statement forecasted. Many ratios and methods can be used to forecast the balance sheet, but we find the asset turnover ratio to be best suited at incorporating the income statement with the balance sheet. Just as sales on the income statement were observed as steadily increasing at a constant rate, the asset turnover ratio is also steadily increasing at a constant rate. The average increase in forecasted asset turnover will correlate to the steady increase observed over the previous 6 years for The Cheesecake Factory. We calculated the forecasted asset turnover ratios by adding 0.03 points to the asset turnover ratio. After calculating the 2014 forecasted ratio we continue to add 0.03 points as a means to forecast the trend seen in the asset turnover ratio of the Cheesecake Factory. Using this method the asset turnover ratio increases by 0.03 points from years 2014 to After 2016 the ratio is constant as a means to not over project based on the asset turnover ratios seen in the previous 6 years. Using this ratio we are able to forecast total assets for the next 10 years. Total assets is the key to forecasting on the balance sheet. Along with the asset turnover ratio we are able to use liquidity ratios as a means to forecast current assets and current liabilities. The next step in forecasting the balance sheet is to create a common size balance sheet to identify trends. After creating the common size balance sheet we noticed a trend of current assets decreasing and increasing and then decreasing again. This mixture of increasing and decreasing led us to use an average of 18.59% in terms of forecasting for current assets. The average will allow us to forecast steady growth, which is seen in the income statement for The Cheesecake Factory. Long-term assets also experienced volatility in terms of increasing and decreasing, therefore we took an average of all the periods and used the number 105 P a g e

106 as the growth for long-term assets for the forecasted periods. Current and long term liabilities experienced more of an increasing trend as compared to current and long term assets. Due to this the projected forecasts increase from 36.70% in 2014 to 57.51% in The trends we have found in The Cheesecake Factory financial statements are on par with trends of the casual dining industry, along with the evidence of a steadily growing economy. 106 P a g e

107 Balance Sheet Current assets: ASSETS AssumeAverage Cash and cash equivalents $80,365 $73,715 $81,619 $48,211 $83,569 $61, % $ 65, $ 70, $ 74, $ 79, $ 84, $ 90, $ 96, $ 102, $ 109, $ 116, Investments and marketable securities 996 Accounts receivable 12,537 11,352 16,184 11,334 14,558 10, % Income tax receivable 12,713 1,875 3,840 5,472 4,529 Other receivables 32,821 27,475 27,296 32,096 48,100 55, % Inventories 23,132 22,202 23,036 28,210 28,836 35, % $ 29, $ 31, $ 33, $ 34, $ 35, $ 35, $ 36, $ 38, $ 39, $ 40, Prepaid expenses 24,654 27,871 28,345 36,498 39,887 42, % Deferred income taxes 3,001 7,737 5,732 14,574 15,257 16,008 Total current assets 190, , , , , , % $ 214, $ 216, $ 223, $ 229, $ 236, $ 243, $ 251, $ 258, $ 266, $ 274, Property and equipment, net 860, , , , , , % $ 850, $ 873, $ 898, $ 925, $ 953, $ 982, $ 1,011, $ 1,041, $ 1,073, $ 1,105, $1,138, Other assets: Intangible assets, net 4,177 4,338 4,498 14,674 17,829 18, % Prepaid rent 58,323 54,243 50,391 49,490 50,793 47, % Other 29,422 27,541 31,988 23,508 28,920 37, % Total otherassets 91,922 86,122 86,877 87,672 97, , % $ 111, $ 121, $ 131, $ 143, $ 155, $ 169, $ 183, $ 199, , Total Noncurrent Assets 952, , , , , , % $ 937, $ 948, $ 977, $ 1,006, $ 1,036, $ 1,067, $ 1,099, $ 1,132, ,166, $ $ 236, $ $ 1,201, Total assets $1,142,630 $1,046,751 $1,028,397 $1,022,570 $1,092,167 $1,124, % $ 1,151, $ 1,165, $ 1,200, $ 1,236, $ 1,273, $ 1,311, $ 1,351, $ 1,391, $ 1,433, $ 1,476, LIABILITIES AND STOCKHOLDERS EQUITY Current liabilities: Accounts payable $37,875 $33,948 $32,651 $36,159 $46,998 $35, % Income tax payable 1,213 Other accrued expenses 147, , , , , , % Total current liabilities 185, , , , , , % $ 245, $ 248, $ 258, $ 261, $ 271, $ 278, $ 288, $ 296, $ 305, $ 314, Deferred income taxes 87,045 87,048 86, ,927 91,852 97, % Deferred rent 57,286 64,209 67,258 69,742 76,144 74, % Deemed landlord financing liability 54,887 51,802 51,954 55,086 55,123 66, % Long term debt 275, ,000 Other noncurrent liabilities 30,013 27,118 27,225 27,822 36,288 44, % Total Noncurrent Liabilities: 504, , , , , , % $ 235, $ 150, $ 72, $ (3,470.68) $ (90,272.31) $ (180,198.47) $ (278,090.57) $ (381,554.99) (492,189.93) Total Liabilities: 690, , , , , , % $ 481, $ 398, $ 330, $ 258, $ 181, $ 98, $ 9, $ (84,970.43) (186,699.55) Commitments and contingencies Stockholders equity: Preferred stock, $.01 par value, 5,000 shares authorized; none issued Junior participating cumulative preferred stock, $.01 par value, 150,000 shares issued Common stock, $.01 par value, 250,000,000 shares authorized; 90,632,325 and 87,812,022 shares issued at December 31, 2013 and 370, , , , , , , respectively 596, , , , , ,451 Additional paid-in capital (9,684) (4,619) $ $ (613,750.36) $ $ (299,537.31) Retained earnings (506,208) (506,208) (558,296) (730,422) (831,814) (1,015,473) % $ (923,248.70) $ (825,777.05) $ (723,100.84) $ (614,794.11) $ (500,413.51) $ (379,497.62) $ (251,566.30) $ (116,119.94) $ 27, $ 183, Accmulated other comprehensive loss Treasury stock 38,865,951 and 34,414,222 shares at cost at December 31, 2013 an 2013, respectively Actual Financial Statements Forecasted Total stockholders equity 452, , , , , , % $ 669, $ 767, $ 869, $ 978, $ 1,092, $ 1,213, $ 1,341, $ 1,476, $ 1,620, $ 1,776, Total liabilities and stockholders equ $1,142,630 $1,046,751 $1,028,397 $1,022,570 $1,092,167 $1,124, % $ 1,151, $ 1,165, $ 1,200, $ 1,236, $ 1,273, $ 1,311, $ 1,351, $ 1,391, $ 1,433, $ 1,476, ROE 9.46% 15.83% 16.16% 18.13% 19.73% 21.24% 19.61% 18.30% 17.23% 16.34% 15.58% 14.92% 14.35% 13.84% 13.61% % change of ROE 6.37% 0.33% 1.97% 1.59% 1.51% -1.63% -1.31% -1.07% -0.89% -0.76% -0.66% -0.57% -0.51% -0.22% TL/SE P a g e

108 Consolidated Financial Statements Forecasted Common Size Balance Sheet Assume Average Assets Current assets: Cash and cash equivalents 7.04% 7.94% 4.71% 7.65% 5.49% 6.57% 5.72% 6.02% 6.23% 6.44% 6.66% 6.89% 7.13% 7.38% 7.64% 7.90% Investments and marketable securities Accounts receivable 1.08% 1.57% 1.11% 1.33% 0.90% 1.20% Income tax receivable Other receivables 2.62% 2.65% 3.14% 4.40% 4.93% 3.55% Inventories 2.12% 2.24% 2.76% 2.64% 3.16% 2.58% 2.60% 2.70% 2.76% 2.77% 2.77% 2.71% 2.73% 2.74% 2.75% 2.74% Prepaid expenses 2.66% 2.76% 3.57% 3.65% 3.79% 3.29% Deferred income taxes Total current assets 16.45% 18.09% 17.25% 21.08% 20.10% 18.59% 18.59% 18.59% 18.59% 18.59% 18.59% 18.59% 18.59% 18.59% 18.59% 18.59% Property and equipment, net 75.32% 73.46% 74.18% 69.99% 70.76% 72.74% 73.87% 74.96% 74.86% 74.86% 74.86% 74.86% 74.86% 74.86% 74.86% 74.86% Other assets: 2.63% 3.11% 2.30% 2.65% 3.30% 2.80% Intangible assets, net 0.41% 0.44% 1.44% 1.63% 1.66% 1.12% Prepaid rent 5.18% 4.90% 4.84% 4.65% 4.19% 4.75% Other 2.63% 3.11% 2.30% 2.65% 3.30% 2.80% Total other assets 8.23% 8.45% 8.57% 8.93% 9.15% 8.67% Total Noncurrent Assets 83.35% 83.55% 81.91% 82.75% 78.92% 82.10% 81.41% 81.41% 81.41% 81.41% 81.41% 81.41% 81.41% 81.41% 81.41% 81.41% Total assets % % % % % % LIABILITIES AND STOCKHOLDERS EQUITY Current liabilities: Accounts payable 4.92% 6.15% 8.29% 9.79% 6.91% 7.21% Income tax payable Other accrued expenses 31.38% 39.00% 38.99% 39.97% 41.85% 38.24% Total current liabilities 37.78% 46.49% 46.53% 49.38% 48.33% 45.70% 51.04% 62.32% 78.00% % % % % % % % Deferred income taxes 16.40% 19.93% 21.66% 17.92% 17.78% 18.74% Deferred rent 12.10% 15.42% 14.54% 14.86% 13.66% 14.12% Deemed landlord financing liability 9.76% 11.91% 11.48% 10.76% 12.11% 11.20% Long term debt 18.85% 18.85% Other noncurrent liabilities 5.11% 6.24% 5.80% 7.08% 8.12% 6.47% Total noncurrent Liabilities 62.22% 53.51% 53.47% 50.62% 51.67% 54.30% 48.96% 37.68% 22.00% -1.34% % % % % % % Total Liabilities % % % % % % % % % % % % % % % % Total Liabilities to Total L&E 50.69% 42.40% 46.92% 46.92% 48.64% 47.12% 41.84% 34.19% 27.55% 20.91% 14.23% 7.51% 0.74% -6.11% % % Stockholders equity: Preferred stock, $.01 par value, 5,000,000 shares authorized; none issued Junior participating cumulative preferred stock, $.01 par value, 150,000 shares authorized; 0.16% 0.14% 0.16% 0.15% 0.16% 0.15% issued Common stock, $.01 par value, 250,000, % 76.76% 62.34% 61.09% 59.33% 67.18% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% shares authorized; 90,632,325 and 87,812,022 shares issued at December 31, 2013 and January 1, 61.10% 70.13% 79.89% 82.64% 88.02% 76.36% 73.87% 74.96% 74.86% 74.86% 74.86% 74.86% 74.86% 74.86% 74.86% 74.86% 2013, respectively Additional paid-in capital Retained earnings 98.08% 94.25% % % % % % % 83.14% 62.86% 45.81% 31.28% 18.76% 7.86% -1.69% % Accmulated other comprehensive loss Treasury stock 38,865,951 and 34,414,222 shares at cost at December 31, 2013 and January 1, 2013, respectively Total stockholders equity % % % % % % % % % % % % % % % % Equity to Total L&E 49.31% 57.60% 53.08% 53.08% 51.36% 52.88% 58.16% 65.81% 72.45% 79.09% 85.77% 92.49% 99.26% % % % Total liabilities and stockholders equity % % % % % % % % % % % % % % % % 108 P a g e

109 Balance Sheet (Adjusted) Actual Financial Statements AssumeAverage Forecasted ASSETS Current assets: Cash and cash equivalents $80,365 $73,715 $81,619 $48,211 $83,569 $61, % $ 64, $ 68, $ 71, $ 75, $ 79, $ 83, $ 87, $ 92, $ 97, $ 102, Investments and marketable securities 996 Accounts receivable 12,537 11,352 16,184 11,334 14,558 10, % Income tax receivable 12,713 1,875 3,840 5,472 4,529 Other receivables 32,821 27,475 27,296 32,096 48,100 55, % Inventories 23,132 22,202 23,036 28,210 28,836 35, % $ 29, $ 31, $ 33, $ 34, $ 35, $ 35, $ 36, $ 38, $ 39, $ 40, Prepaid expenses 24,654 27,871 28,345 36,498 39,887 42, % Deferred income taxes 3,001 7,737 5,732 14,574 15,257 16,008 Total current assets 190, , , , , , % $ 229, $ 236, $ 243, $ 250, $ 257, $ 265, $ 273, $ 281, $ 290, $ 299, Property and equipment, net 860, , , , , , % $ 896, $ 923, $ 951, $ 980, $ 1,009, $ 1,039, $ 1,071, $ 1,103, $ 1,136, $ 1,170, OL CAP RIGHTS $244, $266, $281, $287, $295, $307, Other assets: Intangible assets, net 4,177 4,338 4,498 14,674 17,829 18, % Prepaid rent 58,323 54,243 50,391 49,490 50,793 47, % Other 29,422 27,541 31,988 23,508 28,920 37, % Total otherassets 91,922 86,122 86,877 87,672 97, , % $ 109, $ 117, $ 125, $ 133, $ 143, $ 152, $ 163, $ 174, $ 186, $ 198, Total Noncurrent Assets 1,196,729 1,140,717 1,123,396 1,133,750 1,157,859 1,205, % $ 1,337, $ 1,377, $ 1,418, $ 1,461, $ 1,505, $ 1,550, $ 1,596, $ 1,644, $ 1,694, $ 1,745, Total assets $1,386,948 $1,312,944 $1,309,448 $1,310,145 $1,388,066 $1,431, % $ 1,566, $ 1,613, $ 1,662, $ 1,711, $ 1,763, $ 1,816, $ 1,870, $ 1,926, $ 1,984, $ 2,044, LIABILITIES AND STOCKHOLDERS EQUITY Current liabilities: Accounts payable $37,875 $33,948 $32,651 $36,159 $46,998 $35, % Income tax payable 1,213 Other accrued expenses 147, , , , , , % Total current liabilities 185, , , , , , % $ 263, $ 270, $ 281, $ 285, $ 295, $ 303, $ 313, $ 323, $ 332, $ 342, Deferred income taxes 87,045 87,048 86, ,927 91,852 97, % Deferred rent 57,286 64,209 67,258 69,742 76,144 74, % Deemed landlord financing liability 54,887 51,802 51,954 55,086 55,123 66, % Long term debt 275, ,000 Other noncurrent liabilities 30,013 27,118 27,225 27,822 36,288 44, % OL CAP Liabilities 244, , , , , ,645 Total Noncurrent Liabilities: 748, , , , , , % $ 633, $ 576, $ 511, $ 448, $ 375, $ 299, $ 215, $ 127, $ 31, $ (74,178.28) Total Liabilities: 934, , , , , , % $ 897, $ 846, $ 792, $ 733, $ 670, $ 602, $ 529, $ 450, $ 364, $ 268, Commitments and contingencies Stockholders equity: Preferred stock, $.01 par value, 5,000 shares authorized; none issued Junior participating cumulative preferred stock, $.01 par value, 150,000 shares % $ $ $ $ $ $ $ $ $ $ issued Common stock, $.01 par value, 250,000,000 shares authorized; 90,632,325 and 87,812,022 shares issued at December 31, 2013 and 370, , , , , , % $ 660, $ 637, $ 614, $ 590, $ 566, $ 540, $ 514, $ 487, $ 460, $ 431, , respectively 596, , , , , , % $ 590, $ 570, $ 549, $ 528, $ 506, $ 483, $ 460, $ 436, $ 411, $ 385, Additional paid-in capital (9,684) (4,619) Retained earnings (506,208) (506,208) (558,296) (730,422) (831,814) (1,015,473) % $ (982,950.33) $ (949,451.92) $ (914,948.50) $ (879,409.91) $ (842,805.11) $ (805,102.10) $ (766,267.95) $ (726,268.70) $ (685,069.42) $ (642,634.11) Accmulated other comprehensive loss Treasury stock 38,865,951 and 34,414,222 shares at cost at December 31, 2013 an 2013, respectively Total stockholders equity 452, , , , , , % $ 669, $ 767, $ 869, $ 978, $ 1,092, $ 1,213, $ 1,341, $ 1,476, $ 1,620, $ 1,776, Total liabilities and stockholders equ $1,386,948 $1,312,944 $1,309,448 $1,310,145 $1,388,066 $1,431, % $ 1,566, $ 1,613, $ 1,662, $ 1,711, $ 1,763, $ 1,816, $ 1,870, $ 1,926, $ 1,984, $ 2,044, ROE 9.46% 15.83% 16.16% 18.13% 19.73% 21.24% 19.61% 18.30% 17.23% 16.34% 15.58% 14.92% 14.35% 13.84% 13.61% % change of ROE 67.28% 2.07% 12.22% 8.78% -7.68% -6.68% -5.84% -5.18% -4.64% -4.21% -3.85% -3.56% -1.62% TL/SE P a g e

110 Consolidated Financial Statements Forecasted Common Size Balance Sheet (Adjusted) Assume Average Assets Current assets: Cash and cash equivalents 5.61% 6.23% 3.68% 6.02% 4.31% 5.17% 4.15% 4.23% 4.32% 4.41% 4.51% 4.60% 4.70% 4.80% 4.90% 5.00% Investments and marketable securities Accounts receivable 0.86% 1.24% 0.87% 1.05% 0.70% 0.94% Income tax receivable Other receivables 2.09% 2.08% 2.45% 3.47% 3.87% 2.79% Inventories 1.69% 1.76% 2.15% 2.08% 2.48% 2.03% 1.91% 1.95% 2.00% 2.00% 2.00% 1.96% 1.97% 1.98% 1.98% 1.98% Prepaid expenses 2.12% 2.16% 2.79% 2.87% 2.98% 2.58% Deferred income taxes Total current assets 13.12% 14.21% 13.46% 16.58% 15.78% 14.63% 14.63% 14.63% 14.63% 14.63% 14.63% 14.63% 14.63% 14.63% 14.63% 14.63% Property and equipment, net 60.05% 57.69% 57.89% 55.07% 55.55% 57.25% 57.25% 57.25% 57.25% 57.25% 57.25% 57.25% 57.25% 57.25% 57.25% 57.25% CAP OL RIGHTS 20.27% 21.46% 21.95% 21.32% 21.49% 21.30% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% Other assets: 2.10% 2.44% 1.79% 2.08% 2.59% 2.20% Intangible assets, net 0.33% 0.34% 1.12% 1.28% 1.30% 0.88% Prepaid rent 4.13% 3.85% 3.78% 3.66% 3.29% 3.74% Other 2.10% 2.44% 1.79% 2.08% 2.59% 2.20% Total other assets 6.56% 6.63% 6.69% 7.03% 7.18% 6.82% Total Noncurrent Assets 86.29% 86.88% 85.79% 86.54% 83.42% 85.78% Total assets % % % % % % LIABILITIES AND STOCKHOLDERS EQUITY Current liabilities: Accounts payable 3.63% 4.10% 5.04% 6.12% 4.38% 4.66% Income tax payable Other accrued expenses 20.90% 23.71% 24.38% 25.34% 26.78% 24.22% Total current liabilities 25.16% 28.27% 29.09% 31.30% 30.93% 28.95% 29.34% 31.95% 35.47% 38.89% 44.08% 50.36% 59.27% 71.78% 91.32% % Deferred income taxes 10.92% 12.12% 13.54% 11.36% 11.38% 11.87% Deferred rent 8.06% 9.38% 9.09% 9.42% 8.74% 8.94% Deemed landlord financing liability 6.50% 7.24% 7.18% 6.82% 7.75% 7.10% Long term debt 12.55% 12.55% Other noncurrent liabilities 3.40% 3.80% 3.63% 4.49% 5.20% 4.10% CAP OL LIAB 33.41% 39.19% 37.47% 36.61% 36.01% 36.54% Total noncurrent Liabilities 74.84% 71.73% 70.91% 68.70% 69.07% 71.05% 70.66% 68.05% 64.53% 61.11% 55.92% 49.64% 40.73% 28.22% 8.68% % Total Liabilities % % % % % % % % % % % % % % % % Total Liabilities to Total L&E 60.69% 54.76% 58.57% 58.23% 59.68% 58.39% 57.26% 52.47% 47.67% 42.87% 38.05% 33.19% 28.30% 23.36% 18.36% 13.12% Stockholders equity: Preferred stock, $.01 par value, 5,000,000 shares authorized; none issued Junior participating cumulative preferred stock, $.01 par value, 150,000 shares authorized; 0.16% 0.14% 0.16% 0.15% 0.16% 0.15% issued Common stock, $.01 par value, 250,000, % 76.76% 62.34% 61.09% 59.33% 67.18% 67.18% 67.18% 67.18% 67.18% 67.18% 67.18% 67.18% 67.18% 67.18% 67.18% shares authorized; 90,632,325 and 87,812,022 shares issued at December 31, 2013 and January 1, 48.71% 55.08% 62.36% 65.02% 69.11% 60.06% 2013, respectively Additional paid-in capital Retained earnings 98.08% 94.25% % % % % % % % 89.92% 77.15% 66.35% 57.13% 49.18% 42.28% 36.18% Accmulated other comprehensive loss Treasury stock 38,865,951 and 34,414,222 shares at cost at December 31, 2013 and January 1, 2013, respectively Total stockholders equity % % % % % % % % % % % % % % % % Equity to Total L&E 39.31% 45.24% 41.43% 41.77% 40.32% 41.61% 42.74% 47.53% 52.33% 57.13% 61.95% 66.81% 71.70% 76.64% 81.64% 86.88% Total liabilities and stockholders equity % % % % % % % % % % % % % % % % 110 P a g e

111 Statement of Cash Flows The last part of forecasting financial statements is calculating the statement of cash flows. The statement of cash flows is made up of sections including: cash flows from operating activities or CFFO, cash flows from investing activities or CFFI, and cash flows from financing activities or CFFF. In general, cash flows are naturally volatile, making the statement of cash flows the most difficult to predict. In order to forecast cash flows from operations there are three different ratios we can use: the CFFO/Sales ratio, the CFFO/Operating Income ratio, and the CFFO/Net Income ratio. In terms of the least volatile, we have chosen the CFFO/Net Income method. This method forecasts our CFFO at $46, for 2014 and $62, for P a g e

112 Cheesecake Cash Flows Assume Cash flows from operating acti Net income $52,293 $42,833 $81,713 $95,720 $98,423 $114,356 Adjustments to reconcile net i cash provided by operating activities: Depreciation and amortization 73,290 75,184 72,140 71,958 74,433 78,558 Impairment of assets 2,952 26,541 1,547 5,469 3,294 Realized loss on derivative fi 7,421 7,376 instruments Deferred income taxes 22,179 (4,798) (4,087) 7,907 (12,758) 4,633 Stock-based compensation 13,132 14,610 10,913 9,635 10,838 14,135 Tax impact of stock options ex (822) (1,117) ,435 7,159 net of cancellations Excess tax benefit related to (410) (857) (3,357) (741) (2,801) (7,765) exercised Other (145) 1, ,023 1,259 (464) Changes in assets and liabilities: Change in Current Assets (17,992) 13,825 (9,657) 53,812 (4,304) Change in PPE, net (72,087) (32,934) 3,035 5,915 30,961 Accounts receivable (1,190) 1,185 (4,832) 4,850 (3,224) 4,477 Other receivables 28,224 5, (4,800) (16,004) (6,486) Inventories (834) (5,174) (626) (6,642) Prepaid expenses 3,225 (3,217) (474) (8,153) (3,389) (2,708) Other assets 2,654 5,013 (1,259) (545) (6,533) (3,997) Accounts payable (20,047) (3,927) (1,297) 3,508 10,839 (11,580) Income taxes payable (9,281) 7,865 (1,964) (1,632) 6,685 (5,742) Termination of derivative fina (7,421) (7,376) Other accrued expenses 2,205 29,587 17,984 20,117 30,325 23,557 Average Cash provided by operating act 169, , , , , ,785 Ni Method 2.61 $ 46, $ 36, $ 39, $ 41, $ 44, $ 47, $ 50, $ 54, $ 57, $ 62, OP Method 1.68 $99, $103, $106, $110, $113, $117, $121, $124, $128, $133, Cash flows from investing acti Additions to property and equi (84,907) (37,243) (41,847) (76,746) (86,442) (106,289) Sales of available-for-sale se 11,469 1,000 Additons to intangible assets (870) (1,712) (1,654) Cash used in investing activit (73,438) (36,243) (41,847) (77,616) (88,154) (107,943) Cash flows from financing acti Deemed landlord financing proc 17,862 6,354 4,198 5,070 2,098 13,672 Deemed landlord financing paym (1,247) (1,436) (1,529) (1,687) (1,887) (2,143) Proceeds from exercise of empl 2,669 1,683 30,577 16,146 39,283 72,896 options Excess tax benefit related to , ,801 7,765 exercised Cash Dividends Paid (12,762) (27,191) (Repayment) /borrowings on cre 100,000 (175,000) (100,000) Purchase of treasury stock (172,459) (52,088) (172,126) ######## (183,659) Capital contribution 516 Cash used in financing activit (52,249) (167,542) (115,485) (151,856) (71,859) (118,660) CFFO/Sales Sales method 9.18 CFFO/Net Income NI Income Metho 2.61 CFFO/Operating Income OP INC METHOD 1.68 Dividend Payout (12,762) (27,191) 11.79% $ (30,398.00) (33,983) (37,991) (42,472) (47,481) (53,082) (59,342) (66,341) (74,166) (82,913) Net change in cash and cash eq 43,498 (6,650) 7,904 (33,408) 35,358 (21,818) Cash and cash equivalents at b 36,867 80,365 73,715 81,619 48,211 83,569 of period Cash and cash equivalents at e $80,365 $73,715 $81,619 $48,211 $83,569 $61,751 Average 112 P a g e

113 Common Size Cash Flows Net Income 30.91% 21.73% 49.45% 48.82% 50.38% 55.84% Adjustments to reconcile net income to net cash by Operating Activities Loss on write down of non-cash investment Depreciation and amortization 43.32% 38.14% 43.66% 36.70% 38.10% 38.36% Deferred Income Taxes 13.11% -2.43% -2.47% 4.03% -6.53% 2.26% Stock Based Compensation 7.76% 7.41% 6.60% 4.91% 5.55% 6.90% Excess tax benefit from stock--based compensation -0.24% -0.43% -2.03% -0.38% -1.43% -3.79% Tax benefit from exercise of Stock options -0.49% -0.57% 0.14% 0.43% 1.25% 3.50% Other non-cash items -0.09% Changes in Assets and Liabilities: -9.13% 8.37% -4.93% 27.54% -2.10% Change in Current Assets % % 1.55% 3.03% 15.12% Change in PPE, net Accounts Receivables -0.70% 0.60% -2.92% 2.47% -1.65% 2.19% Inventories 0.55% 0.47% -0.50% -2.64% -0.32% -3.24% Prepaid expenses and other assets 1.91% -1.63% -0.29% -4.16% -1.73% -1.32% Accounts Payable % -1.99% -0.78% 1.79% 5.55% -5.65% Accrued expenses 1.30% 15.01% 10.88% 10.26% 15.52% 11.50% Income Taxes Payable Deferred Construction Allowances Deffered Revenue and other Liabilities Net Cash provided by Operating Activities % % % % % % Cash flows from investing activities: Additions to property and equipment % % % 98.88% 98.06% 98.47% Sales of available-for-sale securities % -2.76% Additons to intangible assets 0.00% 0.00% 0.00% 1.12% 1.94% 1.53% Cash used in investing activities % % % % % % Cash flows from financing activities: Deemed landlord financing proceeds % -3.79% -3.64% -3.34% -2.92% % Deemed landlord financing payments 2.39% 0.86% 1.32% 1.11% 2.63% 1.81% Proceeds from exercise of employee stock -5.11% -1.00% % % % % options Excess tax benefit related to stock options -0.78% -0.51% -2.91% -0.49% -3.90% -6.54% exercised Cash Dividends Paid 0.00% 0.00% 0.00% 0.00% 17.76% 22.92% (Repayment) /borrowings on credit facility % % 86.59% 0.00% 0.00% 0.00% Purchase of treasury stock % 45.10% % % % Capital contribution -0.99% Cash used in financing activities % % % % % % Net change in cash and cash equivalents 25.71% -3.37% 4.78% % 18.10% % Cash and cash equivalents at beginning 21.79% 40.77% 44.61% 41.63% 24.68% 40.81% of period Cash and cash equivalents at end of period 47.50% 37.39% 49.40% 24.59% 42.77% 30.15% 113 P a g e

114 Restated Financial Statements After restating the financial statements for The Cheesecake Factory we have found no significant changes to the income statement or balance sheet. Because The Cheesecake Factory Inc. is a low-quality, low disclosure company they do not disclose goodwill, therefore there is no change to the balance sheet or income statement that is needed. Also, capitalization of operating leases is an immaterial amount in regards to restatements Cost of Capital Estimation To value to the firm, we must estimate the cost of financing Cheesecake Factory. To find an estimate for cost we must understand where the capital comes from and it s cost. Capital derives from either debt or equity. Debt being money borrowed with intentions of principal being paid back plus interest. And equity is a share of ownership in the company. There is no principal and interest due to the investor, only the intention of growth in the shares and possibly a dividend being paid out. We will calculate a cost of capital called WACC, or weighted average cost of capital. This is an expected rate of return on a source of capital that can be compared to competitors within the industry. We will take this discount rate and discount the firm s financials. We will now go in depth about the cost of debt and cost of equity for Cheesecake Factory. 114 P a g e

115 Cost of Debt First step is to calculate the cost of debt. The rate that cheesecake factory is paying in order to finance their debt that is paid to them. Debt can be a simple loan from a bank that does not take control of the company from the existing management. Cheesecake Factory has historically rarely used a large amount of debt to finance their business. The past couple of years there has been nothing for long and short term debt. However, in the most recent quarter, April 1 st 2014, announced $25 million of debt has been reported. Cheesecake Factory poorly discloses information that could allow us to accurately estimate their weighted cost of debt. Unfortunately, the necessary information regarding the interest rate used for their recent outstanding debt fails to be present in Cheesecake Factory s recent 10-K. There a small disclaimer that describes the options of how Cheesecake Factory can choose a rate to finance interest bearing liabilities. Borrowings under the Facility bear interest, at our option, at a rate equal to either (i) the Adjusted LIBOR Rate plus a margin ranging from 1.00% to1.75% based on our Net Adjusted Leverage Ratio or (ii) the highest of (a) the rate of interest publicly announced by JPMorgan Chase Bank as its prime rate ineffect, (b) the Federal Funds Effective Rate from time to time plus 0.5% or (c) the onemonth Adjusted LIBOR Rate plus 1.0%, plus a margin ranging from0.00% to 0.75% based on our Net Adjusted Leverage Ratio. (Cheesecake Factory 10-Q) 115 P a g e

116 There is no specific information related to the $25 million debt, so it up to us to choose an appropriate interest rate. We looked at the possibilities and decided to use the JP Morgan prime rate that is in effect. The current prime rate is 3.25% (Table 1) The Cheesecake Factory's Cost of Debt - As stated Interest Bearing Liabilities Amount (Thousands) Interest Rate Weight Source Weight*Rate Kd Long Term Debt $25, % 100% 10-Q Cheesecake 3.25% 3.25% Weighted Cost of Debt (Table 2) The Cheesecake Factory's Cost of Debt - Restated Interest Bearing Liabilities Amount (Thousands) Interest Rate Weight Source Weight*Rate Kd Long Term Debt $25, % 7.52% 10-Q Cheesecake 0.244% Capitalized Operating Leases $307, % 92.48% 10-K Cheesecake 5.984% $332, % Weighted Cost of Debt We then restated the cost of debt and included the capitalized operating leases, seen on Table 2 shown above. The interest rate we calculated for capitalize operating leases is 6.47%, which is an average of the last 6 years interest rates. We derived the interest rates by taking our total rent expenses and dividing them by the total sales. We then divided the amounts of the debt by the total amount of debt to get each weight. Once we found the weights, we multiplied the weights to the corresponding interest rates, giving us.244% and 5.984%. Finally, we added them together to get a 6.23% weighted cost of debt. Here we see a cost of debt nearly doubled after the restatement. The restatement affects our view of cost of debt. 116 P a g e

117 Cost of Equity The next step in the process of estimating the cost of capital is developing a cost of equity. The cost of equity is the required rate of return that investors and shareholders expect to earn for investing in the firm. This rate is a measure of risk that people expect to take on for the investment they intend to pursue in a specific company. To calculate the expected rate of return we will use the CAPM formula or formally known as the Capital Asset Pricing Model. The CAPM model requires three variables to develop a measure for cost of equity: a risk free rate, a beta, and market risk premium or market risk minus risk free rate. The formula is structured as follows: K e = R f + B ( R m R f ) In order to estimate a risk free rate, we took historical yields from 10 year, 7 year, 2 year, 1 year, and 3 months treasury yields. We took the yields from different timeframes to see the stability over both the short and long term. The numbers we acquired from the Federal Reserve Bank of St. Louis site (FRED) were annualized rates. We divided each rate by 1200 to bring the 10 year yield to a monthly basis. This provided better accuracy for our estimation of a risk free rate that applies to Cheesecake Factory. We also recorded historical monthly prices for the S&P 500 from Yahoo Finance. These numbers will represent the market return that investors or shareholders can expect to earn in addition to the risk free returns. This was calculated simply by reducing the market premium (R m) ) by the risk free rate(r f) ) the correspond with same month. The last remaining variable of the formula is Beta. Beta is listed on Yahoo Finance as.91, but we don t know how they got their beta. Therefore, we had to find a reasonable estimation for beta. We developed our estimation through a 117 P a g e

118 series of regressions. We conducted 5 regressions for each Treasury bond (3 month, 1 year, 2 year, 7 year, and 10 year) with each one varied 12 months apart. This is good because it shows long and short term stability. Above are the 25 regressions for Cheesecake Factory. We used the 2.56% risk free rate from the year Treasury bill in all of our regressions. The table lists beta s that correlate R 2 information and other useful numbers that can help calculate a number for cost of equity. Highlighted in each regression is the 118 P a g e

119 largest number of r-squared. The larger the percentage for r-squared is significant because, the higher the number the more likely the security will move due to the systematic risk. When we analyze The Cheesecake Factory s data, we saw that the highest R 2 of 45.12% is present in the 7 year regression for the 72 month period. However, we decided to use the 36 month cost of equity with a cost of capital of 11.68%. This is the post-recession era and provides for more stable results. Our backdoor cost of equity also falls within the upper and lower bounds. Because of these two reasons we have decided to choose 11.68% cost of equity. From there we can use CAPM to give us a cost of equity (Ke) of 15.66%. We did this by taking our 10 year risk free rate and adding it to the product of our 8%MRP and our Beta of This can be interpreted as the required rate of return for an investor of no less than 15.22%. Next, we used Table 8-5 (Palepu) to determine the size premium that we adjusted to Cheesecake Factory s cost of equity. Throughout history, smaller stocks have been more risky and generated higher returns than larger stocks. This could lead some to assuming that CAPM formula comes with some inaccuracy. To compensate for the size effect we added on the size premium for good measure. We can estimate the appropriate size premium through the Palepu table of historical data. It shows that larger companies often have lower returns and beta rather than smaller stocks. The reasoning behind this pattern is still unknown but fits well for our valuation of Cheesecake Factory. We must first formulate the market value of the company. This is done by multiplying the number of shares outstanding to the current price of a share. MV = (# of outstanding shares Current share price) $2,250,780,000 = 48,300,000 X $46.60 We have calculated that Cheesecake Factory s market value is roughly $2.25 billion. Now, we take the market value and see what its corresponding decile is. 119 P a g e

120 Clearly Cheesecake Factory falls in the size 6 decile category. The corresponding size premium in 6 th decile is 1.8%. We added the size premium to the cost of equity we previously estimated with the CAPM method, 15.22%. We then have a two factor cost of equity of 17.02%. The cost of equity lower and upper bounds from the year 7 regression are 11.77% and 18.66%. The estimated two factor cost of equity will soon be used to help calculate Cheesecake Factory s WACC, weighted average cost of capital. Backdoor Cost of Equity We also performed another way to calculate the cost of equity. The backdoor method is unlike the CAPM model because it is a total risk measure. CAPM is just a systematic risk measurement. The formula is listed below and includes the price to book ratio, growth rate from Cheesecake s IGR, and the return on equity. We used the average of the forecasted IGR for 10 years on a stated and restated basis for our growth rate. The internal growth rate is where no external financing of any sort is obtained, as opposed to the sustainable 120 P a g e

121 growth rate where equity financing cannot be obtained. We wanted to use the IGR because it was the more conservative growth rate, and because it included ROA, which changed when we add the capitalization of the leases. We calculated IGR and SGR by using the following equations: The price to book ratio is currently 4.49 on Yahoo Finance. The ROE, on both a stated and restated basis, is 16.50%. This is the average of all the ROE forecasted for the next 10 years taken from the forecast. The growth rate is the average of the 10 year forecast for the stated and restated IGR, which is 9.19% and 6.87%, respectively. ( Price Book ) = 1 + (ROE Ke Ke g ) In essence, this formula states that the price to book ratio equals the market share price of the firm (the 1 in the equation) plus the firm s growth potential,( ROE Ke ). Inside the parenthesis of the growth potential would be Ke g 1=3.46, indicating that the firm has huge growth potential. The Cheesecake Factory Backdoor Cost of Equity ROE Price/Book IGR Growth Backdoor Ke As Stated 16.50% % 10.81% The Cheesecake Factory Backdoor Cost of Equity ROE Price/Book IGR Growth Backdoor Ke Restated 16.50% % 9.01% 121 P a g e

122 After calculating the as stated backdoor cost of equity, we decided to do a restated backdoor too. We restated IGR because this affects our total ROA, which ultimately affects our IGR growth. We ran an as stated and a restated analysis of the backdoor cost of equity, restating the IGR growth. The as stated and restated backdoor costs of equity are 10.81% and 9.01%, respectively. These both fall within the parameters of our CAPM approach. Weighted Average Cost of Capital (WACC) The weighted average cost of capital displays both the required rate of return for investors, and the firm s average costs in order to finance debt or equity. By taking the weight of the market value of liabilities and the market value of the firm and multiplying them by their cost of debt and equity values, we were able to come up with the average return that is required by all shareholders and investors. Below are the formulas we used to calculate the WACC for before tax and after taxes: WACCbt = (( MVD ) Kd) + ((MVE MVF MVF ) Ke) WACCat = (( MVD ) Kd) + ((MVE) Ke) + (1 Taxrate) MVF MVF To get the as stated market value of debt, we took the 25 million in debt (assuming its interest bearing.) The market value of equity is calculated by taking the number of outstanding shares and the stock price listed on Yahoo Finance, and multiplying them together. After adding the values of market 122 P a g e

123 liability and the value of market equity, we got the market value of the firm. We used this to calculate the weights of each by dividing the value of the market liability and equity by the total market value of the firm. We then multiplied the weights by their respective interest rates. After multiplying the weight and rate, we added them up to get the weighted average cost of capital before taxes. Then, we multiplied the 35% tax rate stated within Cheesecake s 10k by the weighted cost of capital. We subtracted this from the WACC bt to get our WACC at. The WACC at is a more realistic return rate for the investors of the firm because you can t evade taxes and a value before tax can be highly misleading. The Cheesecake Factory has about a 11.57% WACC at. This means that they incur about 11.57% cost when financing their debt or equity. On the restated WACC calculation, we added in the capitalized operating leases. Using the same method as the stated WACC, we have a WACC bt and WACC at of 15.69% and 15.30%, respectively. After adding the capitalized operating leases into the debt, there is only about a 2% decrease in the WACC calculations. This is an indication that a majority of the firms financing is through equity. 123 P a g e

124 WACC-UB Stated Amount (thousands) Weight Rate Weight*Rate WACC bt/at Market Liability $ 25, % 3.25% 0.034% Market Equity $ 2,340, % 19.10% % Market Value of Firm $ 2,365, % WACCbt Tax Rate= 35% 18.91% WACCat WACC-UB ReStated Amount (thousands) Weight Rate Weight*Rate WACC bt/at Market Liability $332, % 3.25% 0.405% Market Equity $ 2,340, % 19.10% % Market Value of Firm $ 2,672, % WACCbt Tax Rate= 35% 16.73% WACCat WACC-LB ReStated Amount (thousands) Weight Rate Weight*Rate WACC bt/at Market Liability $332, % 3.25% 0.405% Market Equity $ 2,340, % 12.21% % Market Value of Firm $ 2,672, % WACCbt Tax Rate= 35% 10.70% WACCat WACC-LB Stated Amount (thousands) Weight Rate Weight*Rate WACC bt/at Market Liability $ 25, % 3.25% 0.034% Market Equity $ 2,340, % 12.21% % Market Value of Firm $ 2,365, % WACCbt Tax Rate= 35% 12.09% WACCat By using the 95% confidence level of the cost of equity, we created 4 charts showing the upper and lower bounds for calculating WACC on a stated and restated basis. On a Stated basis, the upper and lower bound of WACC at are 18.91% and 12.09%. The upper and lower bound of WACC at on a restated basis are 16.73% and 10.70%. Both give a larger margin for our discount rate than the Ke calculation that provided a high of 17.29% and a low of 15.30%. We firmly believe somewhere within the upper and lower bound of the restated WACC at, 16.73% and 10.70%, is where the most realistic weighted average cost of capital lies. 124 P a g e

125 Valuation Analysis Now that we have analyzed the industry, the accounting strategies, and financials, we have valued the company. We used two main methods to value The Cheesecake Factory, market comparative valuation and intrinsic valuation. While intrinsic valuation method is what we consider the more important method of valuation, the market valuation method still holds significant value. The comparative valuation method utilizes competitor numbers along with The Cheesecake Factory's numbers to obtain a price the company should be selling at on the market. Comparative Valuation Table Ratio Market Value at 6/1/2014 Should sell for at 6/1/2014 Overpriced/Underpriced/Fairly Valued Trailing P/E Overpriced Forward P/E Overpriced P/B Overpriced PEG Overpriced P/EBITDA Fairly Valued EV/EBITDA Underpriced When making these valuations we consider ourselves to be 10% analysts. The prices derived change pretty dramatically from ratio to ratio but a trend can be found. The majority of the ratios depict that The Cheesecake Factory is currently overpriced. Below we look into more detail on each of these ratios. 125 P a g e

126 Trailing P/E Competitors Results Brinker 20.4 Average Darden CAKE EPS 2.06 BJ's Should sell McDonalds Value Overvalued To get the trailing P/E ratio we took the trailing P/E of The Cheesecake Factory s competitors and obtained an industry average after taking out any outliers. From that we multiplied the industry average by CAKE s earnings per share to obtain the price that the company should sell for. When we did this we obtained a should sell for price of which, once compared to the market value at 6/1/2014 of 45.87, showed that The Cheesecake Factory is overvalued. Forward P/E Competition Results Brinker Average Darden CAKE EPS 2.06 BJ's Should sell McDonalds Value Overvalued In order to get the forward P/E we follow the same method as trailing P/E by taking a forward P/E industry average after removing outliers. The price obtained from the forward P/E shows a value of which, compared to the market value price at 6/1/2014, shows that The Cheesecake Factory is once again overvalued. The only issue with the forward P/E model is that it relies on the forecasts of each company which, as stated previously, is highly likely to have errors. This makes this model less accurate because the forecasting error that is likely present in the forward P/E will affect the price that comes out of the model. 126 P a g e

127 P/B ratio Competitors Results BJ's 2.44 Average 3.84 McDonalds 6.22 BV/S 10.4 Brinker Should sell Darden 2.86 value Overvalued The P/B method gives us a price in a slightly more complicated manner. Once again we obtained an industry average by getting the average of each relevant competitor s P/B and then multiplying that average by CAKE s book value/share. That result gave us a price that CAKE should sell for of which once compared to the market value at 6/1/2014 resulted in CAKE being overpriced. This model is more reliable than the forward P/E model because it does not require forecasting to obtain an accurate value. Dividends/P We chose not to calculate this ratio for two reasons. The first was a lack of reliable information of the dividends paid by The Cheesecake Factory since the company has only been paying dividends for 1.5 periods and we determined that was not enough time to make a valuation estimate with. The second reason was because the companies that make up the industry have substantially differing dividends and we could not get an accurate average or price with the dividend values provided. 127 P a g e

128 PEG Competition Results Average 2.1 Brinker 1.42 CAKE g 9 Darden CAKE EPS 2.06 McDonalds 2.31 Should sell BJ's 2.56 value Overvalued The PEG value is determined through the following equation: (P/E)/g=PEG. In order to obtain a price from PEG we must take the PEG industry average after removal of outliers. From there we need to multiply that value by CAKE s PEG growth rate and then once more by CAKE s EPS. The issue with that is PEG is determined off of a 5 year growth rate so in order to find the proper growth rate we had to look at the forecasts for future sales for CAKE. After looking at the forecasts we obtained a PEG growth rate of 9%. After multiplying the average by the growth and then multiplying that product by the CAKE EPS we obtained a price CAKE should sell at of which results in CAKE being overpriced. The issue with this model is the same as the issues with the forward P/E model in that it takes forecasting into consideration way too much. This can result in error due to the nature of forecasting. P/EBITDA Competitors Market Cap EBITDA P/EBITDA Results Average Brinker 3,200,000, ,000, CAKE EBITDA 235,000,000 Darden 6,170,000, ,600, Shares outstanding 48,300,000 McD 100,280,000,000 10,130,000, Should sell for BJ's 1,000,000,000 76,370, Value Fair P/EBITDA is determined by taking the P/EBITDA industry average after removal of outliers and multiplying that number by CAKE s EBITDA/CAKE s shares outstanding. In order to get the P/EBITDA for a company we multiplied 128 P a g e

129 the EBITDA by the market cap. This gives us a price that should be sold at which results in CAKE being fairly priced. The only issue with this model is that it does not include income tax, depreciation, or amortization in the determining of the price which can overstate the price since expenses are left in. EV/EBITDA Competitors Results Average BJ's CAKE EBITDA M McDonalds shares outstanding 48.3 M Brinker 9.73 should sell Darden 14 value Undervalued EV/EBITDA is determined in the exact same way as P/EBITDA except it takes the EV/EBITDA industry average after removal of outliers. After calculations we obtained a price to sell at of which results in CAKE being undervalued. This method has the same problems as above in that it neglects to take into account important expenses which skew the results into becoming a higher price due to the lesser expense costs. Intrinsic Valuation Models Although the method of comparables provides us, the financial analysts, with a method to value stocks, the relevancy and accuracy of these methods is often questionable. The method provides coarse views of pricing, with reliability being an issue due to various flaws. In order to analyze the data with more reliability and accuracy we will focus on pricing The Cheesecake Factory with four intrinsic value models: Discounted Dividends, Discounted Free Cash Flow, Residual Income, and Long Run Residual income. These four models are considered to be more valuable than the method of comparables due to various reasons. First, the models possess distinct theories in the formulation of each 129 P a g e

130 intrinsic valuation model, which leads to more accurate depiction of the company s value than can be provided by the method of comparables. The models account for ten years of financial data, as opposed to the comparables only analyzing a single year s performance. Providing ten years of financial data decreases volatility in the model, thus leading to more accurate valuations for the firm. Along with utilizing distinct theories and multiple years of financial data, the intrinsic valuation models also take the time value of money into consideration. Using present values in the model will allow us, the analyst, to be able to determine a more realistic valuation of The Cheesecake Factory. As stated above, the four models we will be using to value The Cheesecake Factory will be the discounted dividends models, the discounted free cash flow model, the residual income model, and the long run residual income model. These four models considerably vary in their explanatory power, however they are more reliable and accurate as compared to the method of comparables. Each of these models possess its own strengths and weaknesses when used for valuing the firm. Therefore, we the financial analysts will obtain a more accurate idea of The Cheesecake Factory s value through the analysis of the above stated intrinsic value models. After we have calculated the estimated growth rate and cost of equity for the models a sensitivity analysis will be performed to explore how responsive the results are to changes in the applied growth and cost of equity rates. Using sensitivity analysis for a wide range of rates will allow us to account for errors in forecasting as well as indicate how varying rates affect the models as a whole. For example, if the models require a cost of equity that hovers around the risk free rate of return to be classified as fairly valued, the firm is overvalued. It is unreasonable for an investor to buy equities in a firm when the risk free government securities are compensated as equally as publically traded firms that bear greater amounts of risk. When classifying the results of the intrinsic valuation models as either undervalued, fair valued, or overvalued, we must set parameters for each of 130 P a g e

131 these scenarios. In order to set the parameters we, the financial analysts, will take the position of a 10% analysts. Taking a 10% analyst position means that unless the price generated from the models varies by a minimum of 10% of the observed price, then the value of the stock will be classified as fairly valued. Applying this position to our June 1 st observed price of $45.87 will reveal results under $ as overvalued and prices over $ as undervalued. If the price from the valuation models falls in between the range of $ and $ then the stock is considered fairly valued. Overall, due to their accuracy and reliability, these four intrinsic value models will be the basis for our final recommendation of The Cheesecake Factory. Discounted Dividends Model The discounted dividends model approximated the stock value of a firm as the present value of the future dividends into a perpetuity. Dividend yield and capital gains return are the two variables that makeup a stock s total return. Although dividends are the only tangible cash flows of a stock, the discounted dividends model ignores the potential cash flows that are a result of capital gains. This model normally considers companies to be overvalued due to its shortcomings and possesses a low explanatory power around 3%. When analyzing the dividend payout it is not uncommon for companies to pay little to no dividends at all. After these payouts are discounted back to present value, the dividend stream is often of insignificant value or nonexistent. The model also assumes the growth rate of dividend payments in perpetuity at a constant rate. Realistically, dividend growth is normally stair stepped, with firms holding dividends constant for an indefinite term and payouts increasing periodically. This makes the smooth growth rate unrealistic. Finally, this model places a large amount of value in the perpetuity portion that is present in the model. Over the course of time forecasts become much less reliable due to volatility in the 131 P a g e

132 forecasted data. Therefore, in order for the model to have a high level of explanatory power the inputs to the model need to be heavily focused on the current value of the company. Based on these reasons, the discounted dividends model has a low explanatory power under 3% as it usually overvalues stocks at this rate. In order to value The Cheesecake Factory using the discounted dividends model we must calculate the annual dividends per share using our ten year forecast. Based off of our statement of cash flows forecast we already have an annual dividend payout for the next ten years. We did this by following The Cheesecake Factory s dividend growth pattern while holding the number of shares outstanding constant. Next, we divide the annual dividend payout by the constant shares outstanding in order to get the annual forecasted dividends per share that we must have for the model. The next step in this process is to discount the individual payments back to the present value using our previously approximated cost of equity and then sum these values. After the values are summed we now have the present value of the forecasted ten year dividend stream. The second part of the model consists of approximating The Cheesecake Factory s dividend payments from year 11 to infinity. In this part we must apply a smooth growth rate in order to calculate the present value of the perpetual dividend stream. For analysis purposes we applied a smooth growth rate of 3% in order to correspond with our average growth for our ten year forecasts. We then use these required inputs to find the value of the perpetuity which is then discounted back to present value dollars. After these two aspects of the discounted dividends model are added together we then have the model s implied price for the end of Because we are valuing The Cheesecake Factory as of June 1 st, 2014, we must grow the present value of the dividend stream at the end of 2013 by five months in order to determine time consistent price. We are using five months of growth due to the The Cheesecake Factory s fiscal year ending at the end of December. Once these steps are performed we are now able to compare the actual closing price of The Cheesecake Factory, 132 P a g e

133 $45.87 on June 1 st, 2014, to the discounted dividend model price. Next, we are able to value The Cheesecake Factory using sensitivity analysis for our cost of equity and growth rate values. We included stated and restated backdoor costs of equity in our sensitivity analysis. Our backdoor cost of equity is determined using the average Internal Growth Rate value for stated and restated financials as the g or growth for the backdoor costs of equity equation. We used IGR as the growth due to it giving us backdoor costs of equity values that fall within the parameters for our cost of equity based upon our previously ran regressions. The Cheesecake Factory's Dividends Sensitivity Analysis 1.0% 2.0% 3.0% 4.0% 5.0% 6.56% % Backdoor Ke 10.81% Ke 11.68% % Cost of Equity As Stated Backdoor Ke Growth Rate 10% Analyst Position < > Overvalued Fair Value Undervalued Re Stated Backdoor Ke Growth Rate 1.0% 2.0% 3.0% 4.0% 5.0% 6.56% % Backdoor Ke 9.01% Ke 11.68% % Cost of Equity 10% Analyst Position < > Overvalued Fair Value Undervalued Based upon our discounted dividends model and our position as 10% analysts, The Cheesecake Factory is consistently overvalued. However, as previously stated, the discounted dividends model usually overvalues companies. Taking this factor into account along with The Cheesecake Factory s dividend yield coincides with the results of the sensitivity analysis. In order for the discounted dividends model to determine The Cheesecake Factory s value the required inputs by the model are implausible. In the sensitivity analysis stated 133 P a g e

134 above there are no instances of the company being fairly valued and only one instance of the company being overvalued, which occurred at a 6.56% cost of equity and a 5% growth rate. If we assume that the Cheesecake Factory s cost of equity is consistent with the calculated size adjusted estimate of 6.56%, a dividend growth rate of 6% is required to produce undervalued results. For the purposes of the model, The Cheesecake Factory is depicted as undervalued whenever the cost of equity is extremely close to the dividend growth rate. Based upon the inputs and assumptions required in order to apply the discounted dividends model, it is possible that the model does not depict the most accurate idea of The Cheesecake Factory s value. However, the models does suggest that The Cheesecake Factory is quite overvalued. Discounted Free Cash Flows Model The second model we will use to value The Cheesecake Factory is the discounted free cash flows model. It s performed by taking the present value of the free cash flows from equity and discounting them to present time. The model operates under the assumption that market value of equity is equal to the market value of assets minus market value of liabilities. Therefore, we need to find the market value of the firm s assets. In the model the market value of assets equals the present value of the annual free cash flows into perpetuity. The year by year free cash flows are discounted back to present value by using the before tax WACC as a means to not count taxes twice, due to forecasted net income being an after tax figure. There are 3 steps involved in performing the valuation. First, we forecasted the free cash flows over a period of time. Second, we calculate the present value of the free cash flows into perpetuity. Lastly, after all future free cash flows have been summed to estimate the market value of The Cheesecake Factory s assets we are then able to value the firm. We are assuming that the book value of liabilities is equal to the market value of 134 P a g e

135 liabilities; therefore subtracting the book value of liabilities from our calculated market value of assets will result in the market value of equity for The Cheesecake Factory. Finally we divide by number of shares outstanding, giving us a value for the year end at The resulting value is then compounded for five months, resulting in a time consistent price that we can use in order to compare the observed price of $ The above picture is the results from the sensitivity analysis from the discounted free cash flow. As 10% analyst, we conclude from the discounted cash flow model that The Cheesecake Factory is understated. The discounted cash flow model can be effective, however, the models downfall is being extremely sensitive to small changes in growth rate. This can lead to drastic changes to the independent and dependent variables of the model. For example, on an as stated bases with a 6.56% cost of capital and only a 1% increase from 4% to 5%, the value jumps over $ Along with being 135 P a g e

136 extremely sensitive the model uses forecasted cash flows, which can be extremely volatile, thus decreasing the validity of the model. Due to these reasons the discounted free cash flows model possesses a low explanatory power and will not have a significant affect in our final valuation of The Cheesecake Factory. Residual Income Model The residual income model is considered to be one of the most accurate and valuable valuation models as compared to the models. The model is considered to have a high explanatory power due to many reasons. First of all, the majority of the input values take into account the current state of the firm rather than relying on perpetuity such as the discounted dividends and the discounted cash flows model. Because forecasts of current and short term figures tend to be more accurate and reliable than the approximation of terminal values, the explanatory power the model possesses is higher than other valuation models. The residual income model is also less susceptible to changes in the applied growth rate. All of these factors combined increase the explanatory power of the model, resulting in higher accuracy when valuing a firm. The residual income model is based upon the comparison between annual net income and the calculated benchmark income. The model also uses the present value of the sum of differences between net income and benchmark income on an annual basis. The differences are then added to the current book value of equity, giving a yield of the market value of The Cheesecake Factory s equity. Due to the process of the model, the first step in the residual income model is to calculate the annual benchmark net income. This calculation is based upon a distortion of the return on equity formula for the firm. Return on Equity is a lagged ratio, with it being defined as net income of the current year divided by 136 P a g e

137 value of equity for the previous year. By using this formula we are able to define the benchmark net income as the firm s cost of equity multiplied by the book value of equity for the previous year. The results are then compared to the net income of the forecasted years, with the difference being defined as residual income. When the residual income is a positive number the firm has created value during the year and the cost of equity was higher than the benchmark. If the residual income is a negative number then the firm did not meet the benchmark net income, with the actual cost of equity falling short of the benchmark cost of equity of the firm. Next, the annual residual income results are discounted back to present value for valuation purposes. The next step in the residual income model involves valuing the perpetual residual income. In order to approximate the value of the annual residual income that is used in the perpetuity we multiplied the 2023 forecasted residual income by 0.8. It is vital that the perpetuity residual income, or 2024 residual income, is calculated as a percentage of the year ten results. Next we take the forecasted residual income for 2024, the perpetuity, and divide it by the cost of equity minus the growth rate for the model. This value is then multiplied by the present value factor of year ten, thus giving us a terminal value for the perpetuity. Next, we take the discounted to present value perpetuity and add it to the present value sum of the year by year residual income and the book value of equity in order to calculate the current market value of equity for The Cheesecake Factory. This value is then divided by the shares outstanding and adjusted accordingly to obtain the time consistent price for June 1 st, The final step in valuation using the residual income model is to perform sensitivity analysis just as we did for the discounted dividends and discounted free cash flow models. However, the sensitivity analysis differs for this model in the respect that the growth rate for the model must be negative. Negative growth rates are due to the fact that in the long run the values of net income and the benchmark net income approach equilibrium, resulting in a residual 137 P a g e

138 income of zero. The sensitivity analysis for the residual income is therefore an application of various rates for cost of equity and negative growth rates. As Stated Backdoor Ke Growth Rate % % Backdoor Ke 10.81% Ke 11.68% % Cost of Equity 10% Analyst < > Lb Fair Value Ub The above table shows our sensitivity analysis for The Cheesecake Factory in regards to as stated backdoor cost of equity. Using a 10% analyst position we have determined that The Cheesecake Factory is overvalued based upon the residual income model. The sensitivity analysis shows that even at the lowest cost of equity, 6.56%, and the lowest growth rate, -50%, the firm will still be overvalued. Based on the trend we assume that at an even lower cost of equity as well as lower growth rate that the firm will still be overvalued in regards to the residual income model. Due to operating leases causing us to restate our financials we must also perform the residual income analysis on a restated basis in terms of backdoor cost of equity. We used restated IGR in our backdoor cost of equity equation for the g or growth portion of the equation. The restated backdoor cost of equity allows us to view the value of the firm on a restated basis, even though the operating leases in the restatements only affect assets and liabilities. By using restated IGR in our backdoor cost of equity formula we produce backdoor cost of equities that fall within our upper and lower bounds in terms of our regressions in order to determine the cost of equity for the firm. 138 P a g e

139 Re Stated Backdoor Ke Growth Rate % % Backdoor Ke 9.01% Ke 11.68% % Ke 10% Analyst < > Lb Fair Value Ub The restated sensitivity analysis using the restated backdoor cost of equity closely resembles the as stated sensitivity analysis. However, the restated backdoor cost of equity is lower than the as stated, resulting in higher numbers in terms of growth rates to cost of equity. Even though the restated backdoor costs of equity valuation numbers vary, the model itself is on par with the as stated model, resulting in the firm being overvalued through the whole model. In conclusion, our sensitivity analysis on both an as stated and restated basis depicts The Cheesecake Factory as being overvalued. This conclusion is supported by the lower and upper boundaries of our cost of equity and growth rates resulting in overvalued prices. Because the residual income model is considered one of the most effective models in order to value a firm these results will have a significant impact on our final recommendation. Long Run Residual Income The long run residual income model is similar to the residual income model in that it estimates the firm s value by calculating the market value of equity. The difference, however, is how the market value of the firm s equity is defined in each model. The residual income model determines the market value of equity by calculating the present value of the forecasted annual residual income figures into perpetuity. The figures are then added to the present book value of equity, as a means to approximate market value of equity. The long run 139 P a g e

140 residual income model, in contrast, does not use yearly forecasts of net income. Instead the long run residual income model requires the current book value of equity, the estimated cost of capital, long run return on equity, and the growth rate. Although this model is not as accurate as the residual income model, it possesses practical application in valuing a firm. Yearly forecasts are not required to complete this model, therefore it can be computed easier than the residual income model. Due to its similarities to the residual income model and it not requiring forecasted values, the long run residual income model can be used as a valuable screening to for the valuation of companies. Long Run Residual Income Formula MVE=BVE0+ BVE0(1+(ROE-KE)/(KE-g)) Because the model is highly dependent on the input rates for Return on Equity, Cost of Equity, and the growth rate, it is sensitive to changes in the input rates. The BVE0(1+(ROE-KE)/(KE-g)) portion of the formula defines the growing perpetuity. The formula assumes that the book value of equity for the firm will continue to grow by the difference between the long run return on equity and cost of equity in perpetuity plus one. In order to value The Cheesecake Factory using this model we must first determine the values for the rates used in the model. Due to The Cheesecake Factory s operating leases only affecting assets and liabilities on a restated basis, ROE does not change between an as stated and restated basis. However, we have decided to use as stated and re stated IGR as a value for the g variable of the backdoor cost of equity model. Our as stated and restated IGR s are positive numbers, which is not normally seen in the growth value of the backdoor cost of equity formula. However, our backdoor cost of equity values fall within our lower and upper bound parameters in regards to cost of equity regression analysis. By using our as stated and restated IGR s we are able to use this model in terms of an as stated and re stated backdoor cost 140 P a g e

141 of equity. Therefore, due to our ROE not experiencing change on an as stated and re stated basis, we are using backdoor cost of equity in the model as a means to produce an as stated and re stated long run residual income sensitivity analysis. Below is the tables for long run residual income using a backdoor cost of equity on a as stated and re stated basis. As Stated Backdoor Ke Hold g constant at -30% Hold ROE constant at 16.50% ROE g 8% 10% 12% 14% 16% -10% -20% -30% -40% -50% 6.55% % % % Backdoor Ke 10.81% Backdoor Ke 10.81% Ke 11.68% Ke 11.68% % % Ke Ke < > < > LB Fair Value UB LB Fair Value UB Hold Ke constant at 11.68% g -10% -20% -30% -40% -50% 11.0% % % % % ROE < > LB Fair Value UB Restated Backdoor Ke Hold g constant at -30% Hold ROE constant at 16.50% ROE g 8% 10% 12% 14% 16% -10% -20% -30% -40% -50% 6.55% % % % Backdoor Ke 9.01% Backdoor Ke 9.01% Ke 11.68% Ke 11.68% % % Ke Ke < > < > LB Fair Value UB LB Fair Value UB Hold Ke constant at 11.68% g -10% -20% -30% -40% -50% 11.0% % % % % ROE < > LB Fair Value UB 141 P a g e

142 In the model we used a cost of equity value of 11.68% that was previously determined in our CAPM and regression analysis. Along with the cost of equity we also used upper and lower boundary cost of equity that were established through our regression. As previously stated we are going to include a sensitivity analysis based upon as stated and re stated backdoor cost of equity. Using as stated and re stated backdoor cost of equity in the valuation allows us to deliver as stated and re stated long run residual income models even though our company does not experience change in ROE. In our sensitivity analysis, both on an as stated and re stated basis, we are using 12% as the centering ROE values when holding growth constant at -30%. We are also using -30% growths as a centering value for as stated and re stated sensitivity when holding cost of equity constant at 11.68%. Lastly, we are using -30% growth as the centering value on an as stated and restated basis when holding ROE constant at 16.50%. Also, we approximate the growth rates used within the long run residual income model. These growth rates are negative due to it being based off of residual income. After applying the formula we divide by the total outstanding shares in order to obtain a value on a per share basis. A major difference between this model and the other intrinsic valuation models used it that it introduces three variables into the equation. Therefore, we must produce three tables related to the three variables in the equation, which can be seen above. These inputs result in the firm being overvalued based upon the long run residual income model regardless of the applied rates. The firm is determined as overvalued with respects to holding growth constant, holding cost of equity constant, and holding return on equity constant, in terms of as stated and re stated backdoor costs of equity. Overall, the long run residual income model indicates that The Cheesecake Factory is consistently overvalued relative to the observed stock price of $45.87 on an as stated and re stated basis. Therefore, we will significantly take the long run residual income model into consideration when determining our final recommendation for The Cheesecake Factory. 142 P a g e

143 Analyst Recommendation To recap the valuation process of Cheesecake Factory, we started with analyzing the firm and the industry it is a part of. We looked at the nature of the business and identified the three biggest competitors to Cheesecake Factory being Brinker Intl., Darden Inc., and BJ s Restaurants Inc. We researched these competitors and identified their strengths and weakness and how well their financial statements compare to Cheesecake Factory. With this research we developed a five force model giving us more insight into the upscale casual dining industry. After we gained a better understanding of the casual upscale dining industry, we look internally into Cheesecake Factory to learn more about their key accounting policies and strategies to determine if there are any possible distortions within their financial statements. We came across a poor quality of disclosure throughout the entire Cheesecake Factory 10-K as relevant information relating to liabilities was not present. One distortion relating to their liabilities was Cheesecake s operating leases. To correct this distortion, we restated their liabilities with capitalization of the leases to give our valuation a more accurate analysis. We forecasted Cheesecake Factory s statements with data that were based off trends and ratios found in previous years. We further continued the valuation process by analyzing the forecasted statements as well as the ratio analysis that give us further insight on the financial position of Cheesecake Factory. With this calculated data, we ran the intrinsic valuation method. The intrinsic valuation method consists of four models that include discounted dividends, discounted cash flows, residual income, and long run residual income. These models use sensitivity analysis to determine 143 P a g e

144 whether the current price is undervalued, overvalued, or fair. This method allows our valuation to have more certainty and accuracy in our recommendation. Our biggest indicator from the intrinsic valuation is the residual income model on a stated and restated basis. The data formulated in this model is based upon the 10% analyst position that we have taken, as well as the current stock price $45.87 on June 1 st, These models only resulted in overvalued price of The Cheesecake Factory in terms of cost of equity and growth rates. Therefore, our recommendation as financial analysts is that The Cheesecake Factory is overvalued, and investors holding Cheesecake Factory stock should sell. 144 P a g e

145 Appendices LIQUIDITY RATIOS Current Ratio Brinker Darden BJ's CAKE Quick Ratio Brinker Darden BJ's CAKE Inventory Turnover Brinker Darden BJ's CAKE P a g e

146 Inventory Days Brinker Darden BJ's CAKE Accounts Receivable Turnover Brinker Darden BJ's CAKE A/R days Brinker Darden BJ's CAKE P a g e

147 Cash to Cash Brinker Darden BJ's CAKE Working Capital Turnover Brinker Darden BJ's CAKE PROFTIABILITY RATIOS Sales Growth Brinker N/A 24.15% 12.73% 4.22% 2.35% 0.66% Darden N/A BJ's N/A CAKE N/A P a g e

148 Gross Profit Margin Brinker Darden BJ's CAKE Operating Profit Margin Brinker Darden BJ's CAKE Net Profit Margin Brinker Darden BJ's CAKE P a g e

149 Asset Turnover Brinker Darden BJ's CAKE Return on Assets Brinker 2.36% 2.36% 2.36% 2.36% 2.36% 2.36% Darden BJ's CAKE Return On Equity Brinker 9% 9% 9% 9% 9% 9% Darden BJ's CAKE P a g e

150 IGR & SGR 150 P a g e

151 CAPITAL STRUCTURE RATIOS Debt to Equity Ratios CAKE CAKE Restated Brinker Darden BJ s Z-Score CAKE Cake Restated Brinker Darden BJ s Times Interest Earned CAKE Cake Restated Brinker Darden P a g e

152 3 MONTH REGRESSION 152 P a g e

153 153 P a g e

154 1 YEAR REGRESSION 154 P a g e

155 155 P a g e

156 2 YEAR REGRESSION 156 P a g e

157 157 P a g e

158 158 P a g e

159 7 YEAR REGRESSION 159 P a g e

160 10 YEAR REGRESSION 160 P a g e

161 161 P a g e

162 COMPAREABLES Trailing PE Brinker 20.4 Darden BJ Mcdonalds Future P/E Brinker Darden BJ Mcdonalds P a g e

163 P/B Average Mcdonalds BJ Brinker Darden BV/S 10.4 Should sell PEG Average Brinker Darden McD BJ CAKE g 9.00 CAKE EPS 2.06 should sell P a g e

164 Cap EBITDA P/EBITDA Brinker 3,200,000, ,000, Darden 6,170,000, ,600, McD 100,280,000,000 10,130,000, BJ's 1,000,000,000 76,370, EV EBITDA Brinker Darden McD BJ Average Cake EBITDA 235,800,000 Shares Outstanding 48,300,000 Should sell P a g e

165 VALUATION MODELS DISCOUNTED DIVIDENDS 165 P a g e

166 FREE CASH FLOW MODEL 166 P a g e

167 RESIDUAL INCOME LONG RUN RESIDUAL INCOME Ke 11.68% As Stated ReStated Estimated Price per Share (end of 2013) Backdoor Ke 10.81% 9.01% Observed Share Price $45.87 Book Value Equity (THOUSANDS) 577,353 ROE (Based on Trend) 19.00% As Stated Backdoor Ke Ke (What initial Ke is) 11.68% Hold g constant at -30% Hold ROE constant at 16.50% g g (ROE cannot outperform Ke) -50% ROE 8% 10% 12% 14% 16% -10% -20% -30% -40% -50% Model Price 12/21/87 (MVE) % % Divide by shares % % Model share price Backdoor Ke 10.81% Backdoor Ke 10.81% FV Factor (5 months) 1.05 Ke 11.68% Ke 11.68% % % Time consistent price Ke Ke < > < > LB Fair Value UB LB Fair Value UB Hold Ke constant at 11.68% g -10% -20% -30% -40% -50% 11.0% % % Analysis: Overvalued (Sell) 16.5% % ROE < > LB Fair Value UB Restated Backdoor Ke Hold g constant at -30% Hold ROE constant at 16.50% ROE g 8% 10% 12% 14% 16% -10% -20% -30% -40% -50% 6.55% % % % Backdoor Ke 9.01% Backdoor Ke 9.01% Ke 11.68% Ke 11.68% % % Ke Ke < > < > LB Fair Value UB LB Fair Value UB Hold Ke constant at 11.68% g -10% -20% -30% -40% -50% 11.0% % % % % ROE < > LB Fair Value UB 167 P a g e