CAKE – LOOKING FOR THE FOLLOW UP!

Last week one of my competitors downgraded CAKE to a sell after the company reported earnings. The analyst cited a numbers of factors for the downgrade, but the focus was clearly on the balance sheet and fear that the company could not handle its debt. The report basically regurgitated the company’s press release regarding its newly amended credit agreement. If fact, the research report, while citing significant balance sheet concerns, only included an income statement and not a balance sheet or cash flow statement. This seems slightly irresponsible in the current environment, where accountability is king.

Concerns over CAKE’s ability to stay below its maximum Debt/TTM EBITDA debt covenant are overblown. To be clear, fiscal 2009 will be another challenging year for CAKE. Based on the company’s EPS guidance of $0.57-$0.67, the company could face a nearly 20% decline in EBITDA after falling 8% in 2008. Partially offsetting that decline, however, is the fact that the company ended 2008 with over $80 million in cash.

After a more detailed analysis of CAKE financials, you can’t come to the same conclusion as my competitor that CAKE is at risk of defaulting on its covenant. In fact, using the analyst’s estimates the company is not anywhere close to tripping a debt covenant. Even assuming the low end of the company’s guidance, CAKE does not come close to tripping a debt covenant. In fact, it would take a decline in current trends for the company to come in at the low end of its guidance and a significant deceleration for the company to default. I have waited some time since the initial report to see if there would be any follow up with the supporting documentation. Needless to say, the downgrade on CAKE includes only one paragraph, no balance sheet and no supporting documents two weeks later. The conclusion – buy the controversy. But there is no controversy.

CAKE amended its revolving credit facility earlier this year, resetting its leverage ratio (defined as funded debt to trailing 12-month earnings before interest, taxes, depreciation, amortization and non-cash stock option compensation expense, or “EBITDA”) from a maximum of 2.25 to a maximum of 1.75 through 1Q09 and a maximum of 1.50 thereafter. It is this covenant step down in 2Q09 that has some investors worried. Based on our calculations, if CAKE’s 2009 numbers were to come in at the low end of the company’s guidance, which I think assumes that things get worse from here, the company still has the potential to generate over $65 million in net cash flow from operations or cash from operations after the planned $45-$50 million in capital expenditures. This free cash flow combined with the $80 million of cash on hand gives CAKE the flexibility to pay down enough cash in the first half of the year to stay in accordance with its covenant. Specifically, if the company pays down only $50 million in debt in 1H09, which is conservative, CAKE’s EBITDA would still have to decline by another $3.5 million in 2Q09 off of what are already extremely conservative estimates for the quarter with EBITDA down 18% year-over-year. Assuming the company only needs to maintain a cash balance of about $25 million rather than the current $80 million on hand, this $3.5 million EBITDA cushion in 2Q09 on a gross debt basis grows to nearly $33 million on a net debt basis because CAKE currently has such a substantial cash balance.

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