Why This Restaurant Has Massive Growth Ahead

This article contains Cheesecake Factory, Darden Restaurants, and Denny's. The author has no positions in Cheescake Factory, Darden Restaurants, or Denny's.

Ranked as America's best restaurant chain by Forbes, the Cheesecake Factory is up 27% since early January, outperforming most competitors in the casual-restaurant space. However, even tastier returns for the Cheesecake Factory's shareholders may be on their way. What makes this restaurant so special?

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International expansion
Formed in 1978, The Cheesecake Factory didn't open its fourth restaurant until 1990. Today, it operates more than 170 restaurants. Only three of them are located abroad. But that's about to change.

The company could benefit enormously from international expansion. There are concrete plans to open more locations in the Middle East --where the company mentioned there were long lines and strong demand at the three restaurants it opened last year-- and move into Latin America, where its first restaurant will open in 2014 in Mexico City.

In the Middle East, the company has a partnership with Alshaya, which was behind the successful opening of various franchises, including Starbucks and H&M. Thanks to this agreement; the company plans to develop 22 restaurants by 2016 in United Arab Emirates, Kuwait, Bahrain, Qatar and Saudi Arabia.

Considering partner Alsea will develop at least 12 restaurants in Latin America over the next eight years, it is safe to assume that an increase in international exposure is in the making, with 34 international locations secured.

Overall, I find this a great beginning for international expansion. The company could probably open more restaurants, considering it has a strong reputation in the U.S. and that several other restaurants have replicated their American business model successfully. But The Cheesecake Factory is strategically testing the markets first. This take will help the company have a better understanding of its new customers' preferences.

Rock-solid fundamentals
The company reported excellent financial performance in 2012, when it achieved its highest earnings ($1.88 per share), highest margins (8.2%) and highest revenue ($1.8 billion) since 2008. More recently, in the second quarter of 2013, it posted sales of $470 million and pro forma earnings per share of $0.54.

Although both numbers missed the Street consensus, the poor 0.9% quarterly sales growth could have cyclical reasons, this is a period where Easter and spring breaks decrease consumer base. Notice that April was weak, while May was pretty solid.

More important, the company increased its menu price 1% and 0.8% during the first quarter of 2013 and third quarter of 2012 . A decrease in discretionary spending combined and a more expensive menu had a negative effect on sales growth.

Increasing dividend and share repurchases
In July, the Cheesecake Factory reported $130 million in cash and equivalents, and almost three times more assets than liabilities. But the company is not only in good financial health; it is committed to return cash to shareholders. It will return almost 60% of the cash flow generated last year to investors, via dividends and share repurchases. Notice the board of directors just agreed to increase the dividend by 17% and its share repurchase authorization by 18%, to 48.5 million shares.

With 95% of its 1,690 franchised restaurants located in the U.S. market, Denny's also has plenty of room for international expansion. Unlike the Cheesecake Factory, Denny's shifted to a franchise model in 2007 and now only 10% of its restaurants are company owned.

The change helped Denny's to improve its free cash flow and profitability. However, Denny's main weakness is its lack of revenue growth.The latest quarter came in with a 0.5% decrease in sales at company restaurants, and only a 0.7% increase at domestic franchised restaurants. It only generated $12.6 million of free cash flow. The upside is that by being heavily franchised, Denny's has limited downside risk because of lower capital requirements.

Down 20% from a 52-week high, Darden Restaurants is priced more attractively. Owner of Red Lobster and LongHorn Steakhouse brands, the company calls itself the world's largest full-service restaurant, employing more than 200,000 people.

But there is a reason why Darden is cheap. Although the company has meaningful scale advantages, its managementhas admitted it will be difficult to keep its current price premium in an increasingly fierce space. Despite owning the buildings and sometimes the land where it operates, profitability remains an open issue; fourth quarter net earnings per share showed a 12% decrease from last year.

Apart from economies of scale, Darden may have few competitive advantages. Its Red Lobster brand is highly exposed to the increasing cost of shrimp. A sudden decrease in supply could set menu prices even higher, making more Darden customers shift to more affordable fast-casual diners.

Final Foolish thoughts
With a menu made from scratch containing more than 200 options, the Cheesecake Factory is preferred by all types of consumers and has a strong reputation for taste and quality. This suggests its business model can be replicated abroad, where there are only three locations. Therefore, the company should be trading at a higher price-to-earnings ratio. Its growth opportunities remain intact.

The article Why This Restaurant Has Massive Growth Ahead originally appeared on Fool.com.

Adrian Campos has no position in any stocks mentioned. The Motley Fool owns shares of Darden Restaurants. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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