Cheesecake Factory Inc (NASDAQ: CAKE) easily outperformed the Consumer Discretionary sector by 17.1% as it relates to ROE, producing a strong 25.9% compared to the sector’s 8.8%. But what is more interesting is whether Cheesecake Factory will continue to achieve superior returns moving forward. The DuPont analysis is a useful tool that may help us determine this. In my analysis below, I’ll use the DuPont model to reveal what’s really driving the company’s strong ROE.
Cheesecake Factory’s ROE Trends
Return on equity or ROE represents the percentage return a company generates on the money shareholders have invested.
ROE = Net Income To Common / Average Total Common Equity
In general, a higher return on equity suggests management is utilizing the capital invested by shareholders efficiently. However, it is important to note that ROE can be impacted by management’s financing decisions such as the deployment of leverage.
Cheesecake Factory’s recent ROE trends are illustrated in the chart below.
source: finbox.io data explorer – ROE
It appears that the return on equity of Cheesecake Factory has generally been increasing over the last few years. ROE increased from 20.4% to 23.4% in fiscal year 2016, increased to 25.9% in 2017 and the LTM period is also its latest fiscal year. So what’s causing the general improvement?
What’s Causing Cheesecake Factory’s Improving Return On Equity
A less used approach although being much more intuitive, the DuPont formula is another way to calculate a company’s ROE. It is defined as:
ROE = Net Profit Margin * Asset Turnover * Equity Multiplier
Created by the DuPont Corporation in the 1920s, the analysis is a useful tool that helps determine what’s responsible for changes in a company’s ROE. It highlights that a firm’s ROE is affected by three things: profit margin, asset turnover, and its equity multiplier or financial leverage.
Analyzing changes in these three items over time allows investors to figure out if operating efficiency, asset use efficiency or the use of leverage is what’s causing changes in ROE. Strong companies should have ROE that is increasing because its net profit margin and/or asset turnover is increasing. On the other hand, a company may not be as strong as investors would otherwise think if ROE is increasing from the use of leverage or debt.
So let’s take a closer look at what’s causing Cheesecake Factory’s improving returns.
Cheesecake Factory’s Net Profit Margin Trends
A promising sign for shareholders, Cheesecake Factory’s net profit margin has increased each year since 2015. Margins increased from 5.5% to 6.1% in fiscal year 2016, increased to 7.0% in 2017 and the LTM period is also its latest fiscal year.
As a result, the company’s improving margins help explain, at least partially, why ROE is also improving. Now let’s take a look at Cheesecake Factory’s efficiency performance.
Cheesecake Factory’s Asset Turnover Trends
It appears that asset turnover of Cheesecake Factory has generally been declining over the last few years. Turnover increased from 1.75x to 1.80x in fiscal year 2016, decreased to 1.72x in 2017 and the LTM period is also its latest fiscal year.
source: data explorer – asset turnover
Therefore, the company’s ROE improvement is not as a result of its asset turnover performance which has generally been decreasing.
Finally, the DuPont constituents that make up Cheesecake Factory’s ROE are shown in the table below. Note that the table also compares Cheesecake Factory to a peer group that includes Domino’s Pizza Inc (NYSE: DPZ), Chipotle Mexican Grill, Inc. (NYSE: CMG), Brinker International, Inc. (NYSE: EAT) and Buffalo Wild Wings, Inc. (NASDAQ: BWLD).
source: finbox.io’s DuPont model
In conclusion, the DuPont analysis has helped us better understand that Cheesecake Factory’s general improvement in return on equity is the result of steadily improving net profit margin, a declining asset turnover ratio and increasing leverage. Therefore when looking at the core operations of the business, Cheesecake Factory shareholders have reason to be excited due to the company’s steady improvement profitability along with a general decline in operational efficiency and increasing leverage.
The DuPont approach is a helpful tool when analyzing how well management is utilizing shareholder capital. However, it doesn’t necessarily tell the whole story. For example, how do the company’s ROE trends compare to its peers or sector? How about in absolute returns? I recommend that investors continue to research Cheesecake Factory to gain a better understanding of its fundamentals before making an investment decision.
As of this writing, I did not hold a position in any of the aforementioned securities and this is not a buy or sell recommendation on any security mentioned.