www.ReformCakeGovernance.info
APRIL ??, 2003
Chris Bohner
702-387-7005
cbohner@hereunion.org
Genevieve Parente
702-386-5118
gparente@culinarylocal226.org
Having Their Cake And Eating It Too:
The Impact of Stock Options at The Cheesecake Factory
While The Cheesecake Factory (NASDAQ:CAKE) has been a favorite of
Wall Street analysts, consistently growing at 20% or more a year,
investors should be aware of the impact of the company's
prodigious use of stock options:
16 million stock options, and the party isn't over! Since
1992, CAKE has authorized over 16 million stock options for
employees, executives, and directors of the company (as of 2002,
CAKE had 49 million shares outstanding). From 1995 through 2002
more than 7.6 million stock options have been exercised by
employees or over 15% of outstanding shares in 2002 leading
to significant dilution at the company. At the end of 2002,
CAKE's option overhang (the number of options outstanding and
available for grant divided by shares outstanding) was over 17%.
That means there is the potential of an additional 17% of the
company's shares being introduced into the market, further
diluting shareholders.
Non-recurring stock option tax benefits account for a large
portion of operating cash flow at CAKE. While CAKE records no
option expense in the income statement, the company has seen a
major boost in operating cash flow as a result of stock options.
In 2002, 27% of CAKE's operating cash flow was likely due to the
tax benefit of stock option exercises. Because CAKE doesn't
directly disclose the tax benefit in the cash flow statement as
many companies do, investors may be unaware that a reduction in
option exercises could reduce CAKE's operating cash flow and
ability to self-finance capital expenditures.
Is CAKE financing Capex through stock options? One of the
selling points frequently offered by sell-side analysts covering
CAKE and by the company itself is CAKE's apparent ability to
finance its growth and capital expenditures (Capex) internally
from the company's cash flow. However, if you exclude the
benefits of stock options from operating cash flow, CAKE actually
had negative free cash flow of over -$18 million in 2002.
A significant source of cash on CAKE's balance sheet is due
to non-recurring stock option benefits. While CAKE has been
lauded for its strong balance sheet, stock option exercises --
and the associated tax benefits -- appear to account for at least
$59 million of the $62 million of the growth of cash on CAKE's
balance sheet since the beginning of 1998.
EPS significantly lower if options recognized as
compensation expense. A review of CAKE's disclosures shows that
CAKE's reported diluted EPS would have been reduced by an average
of 15% each of the last three years if stock option grants had
been expensed in the income statement--that's a significantly
higher reduction in EPS than CAKE's key peers. Would CAKE hand
out stock options as aggressively if the company was required to
expense those options in the income statement, as many in the
investment community now recommend?
No shareholder approval of key stock option plan, and the
stock repurchase plan is a vehicle for issuing more options
Despite the significant dilutive potential, a stock option plan
with over 5.3 million authorized shares has not been approved by
CAKE shareholders. In addition, while CAKE's stock repurchase
program is supposed to "minimize the dilutive effect of ongoing
employee stock option exercises," all the repurchased shares have
been "reissued" as stock options available for grant in the plan
not approved by shareholders.
It's time to change. To address the option issues, CAKE
should voluntarily adopt a number of changes, including improving
disclosure in the company's financial statements. In addition,
shareholders can support our proposals at the May, 2003 annual
meeting urging CAKE to improve corporate governance, expense
stock options, and submit all option plans for shareholder
approval.
Introduction
The Cheesecake Factory (NASDAQ:CAKE)an upscale, full service
casual dining company with 61 restaurants has been a favorite of
Wall Street analysts, consistently growing at 20% or more a year
with no debt and high cash flow. As a result, CAKE is trading at
one of the highest P/E ratios in the casual dining stock
universe.
Despite CAKE's impressive performance, one aspect of the
Cheesecake Factory story that hasn't been told is the impact of
the company's prodigious use of stock options. Over the last
decade, CAKE shareholders have seen their stake in the company
significantly diluted though stock option grants to employees,
and shareholders are at risk for even greater dilution given the
company's high "option overhang."
But option dilution is only part of the story. CAKE also
illustrates how the current accounting and regulatory environment
allows companies to systematically understate the true costs of
stock option plans, and even avoid shareholder ratification of
option plans. Lacking clear information on costs (or even the
right to vote on some option plans), it's little surprise that
shareholders may be unaware about stock option dilution at CAKE.
But what is surprising about the option story at CAKE is the role
stock options play in overstating the financial performance of
the company. Perversely, while CAKE is not required to deduct the
compensation expense of stock options from earnings, the company
benefits from a significant boost to operating cash flow and the
balance sheet from stock option exercises and the associated tax
benefits. These benefits, which are not necessarily recurring
nor immediately obvious from a reading of CAKE's financial
statements, further muddy the murky world of option accounting.
Clearly, the goal of transparency is not served when CAKE can
avoid accounting for the costs of significant option grants that
lead to dilution, while at the same time benefiting from stock
option exercises that boost the balance sheet and cash flow
statement. Moreover, approving stock option plans without
shareholder approval or announcing stock repurchase plans that
are a method of issuing more stock options, does not contribute
to a high standard of "quality and integrity," as the company
pledges.
Ultimately, there is no law or regulation stopping CAKE from
restoring transparency and integrity to the company's treatment
of stock options. CAKE could voluntarily adopt a number of
changes, including expensing stock options, submitting option
plans for shareholder approval, and improving disclosure in its
financial statements. Unfortunately, without significant
changes to the company's corporate governance and accounting
standards, we fear that CAKE will continue to have its cake and
eat it too.
Below we detail the option story at CAKE with some
recommendations.
SIDEBAR
"We strive to make our financial statements as clear and
straightforward as we can, and we apply the same high standards
of quality and integrity to our corporate finance and accounting
practices that we apply to the protection of The Cheesecake
Factory brand itself."
1. Too Much CAKE: Stock Option Dilution
Since 1992, CAKE has authorized over 16 million stock options for
employees, executives, and directors of the company (as of 2002,
CAKE had 49 million shares outstanding). The result is steadily
increasing dilution at the company, and a transfer of wealth from
shareholders to employees.
From 1995 through 2002 more than 7.6 million stock options have
been exercised by employees or over 15% of outstanding shares in
2002 -- accounting for a large portion of the growth of
outstanding shares at CAKE from 37 million shares in 1995 to 49
million shares in 2002 (adjusted for stock splits).1
And CAKE shareholders may see further dilution in the future
given the high number of options outstanding and available for
future grant, the so-called "option overhang." At the end of
2002, CAKE's option overhang was 17.1%. That's significantly
higher than the 2001 national average of 14.7% and CAKE's
key competitors such as P.F. Changs (PFCB) and California Pizza
Kitchen(CPKI).1
Table 1: 2002 Option Overhang
SIDEBAR
CAKE shareholders may see further dilution in the future given
the high number of options outstanding and available for future
grant.
2. Option Expense, Diluted EPS, and Disclosure at Cake
Would CAKE be as generous with stock options if those options
were expensed in the income statement, as many institutional
investors and corporate governance experts are currently
advocating?
According to SFAS No. 123, "Accounting for Stock-Based
Compensation,"companies are only required to report the
compensation expense of stock options (using the Black-Scholes
method) in the 10K footnotes.3 A review of CAKE's disclosures
shows that CAKE's reported diluted EPS would have been
reduced by an average of 15% each of the last three years if
stock option grants had been expensed in the income statement
that's significantly higher than PFCB or CPKI (see Table 2).
Table 2: Reduction in EPS if Options Were Expensed
One cautionary note regarding CAKE's disclosures regarding SFAS
No. 123. In reviewing CAKE's annual reports, there were
discrepancies from year to year regarding the disclosure of the
impact of expensing stock options on net income (i.e. pro forma
net income). In the 2002 10K, CAKE lists 2000 pro forma net
income as $26.6 million, while the 2001 10K uses $23.5 million as
2000 pro forma net income. There are similar discrepancies
regarding 1999 pro forma net income. CAKE should provide more
information and disclosure to shareholders regarding these
discrepancies.
Nevertheless, using either disclosed pro forma net income figure,
the data show that there is a significant cost to CAKE's stock
option program, one which would be made clearer if the cost was
expensed on the income statement. While shareholders are seeing
many of the indirect benefits of CAKE's stock option program in
the balance sheet and cash flow statement (see below),
shareholders are not seeing the true costs. To be truly
transparent to its shareholders, CAKE should follow the lead of
companies like Coca Cola and begin voluntarily expensing stock
option expense in the income statement.
SIDEBAR
There is a significant cost to CAKE's stock option program, one
which would be made clearer if the cost was expensed on the
income statement.
Diluted EPS: An Alternative to Expensing Options?
Some critics argue that expensing options is unnecessary because
the diluted EPS number accounts for the costs of stock options.
However, the method used for calculating diluted shares seriously
underestimates stock option dilution. Under the Treasury Stock
Method (TSM), dilution is calculated by assuming all
stock options in-the-money are exercised. However, the TSM
method further assumes that the proceeds to the company from the
options exercised -- and the associated tax benefits -- are used
to repurchase shares at the current market price. The
differential between the options exercised and the shares
theoretically purchased is the number used to calculate diluted
EPS.4
However, the TSM bears little resemblance to reality at CAKE.
Rather than repurchase shares from the proceeds of stock option
exercises, CAKE has let most of that cash pile up on the balance
sheet. From 1999 through 2002, CAKE has received over $88
million from stock option proceeds including the tax benefits,
but has spent only $13 million to repurchase shares a 14.6%
rate. Thus the diluted EPS number reported by CAKE seriously
underestimates CAKE's actual practices.
Take 2002 as an example. In 2002, CAKE reported that the
difference between basic and diluted shares was 1.9 million using
the Treasury Stock Method. However, at the end of the fiscal
year 2002, CAKE had approximately 5.2 million outstanding options
that were in-the-money (as of 12/31/02). The diluted EPS number
used by CAKE and by shareholders and analysts -- assumes
that CAKE would theoretically purchase 3.3 million shares with
all its option proceeds. But as noted in the previous paragraph,
CAKE has historically used only 14.6% of option proceeds to
repurchase shares. Applying that rate, CAKE would repurchase
only 763,000 shares rather than 3.3 million assumed for
calculating diluted EPS. Adjusting the reported diluted EPS by
CAKE's actual practice would lead to a "real" diluted EPS 5%
lower for 2002 than reported (see Table 3).
SIDEBAR
The diluted EPS number reported by CAKE seriously underestimates
CAKE's actual practices.
Table 3: Diluted vs. "Real" Diluted
3. The Hidden Impact Of Stock Option Tax Benefits on CAKE's
Operating Cash Flow
One of the selling points frequently offered by sell-side
analysts covering CAKE and by the company itself is CAKE's
apparent ability to finance its growth and capital expenditures
(Capex) internally from the company's operating cash flow. For
example, on CAKE's third quarter conference call CFO Gerald
Deitchle told investors that CAKE is "a very successful, cash
flow positive company. And we're a real company with real cash
flows. Each one of these Cheesecake Factory restaurant[s] - these
little sweethearts throw off at least two million of operating
cash flow a year. And we are self-financing our capital
expenditures today and our current growth plans today."5
Echoing the point, Banc of America Securities recently wrote that
CAKE "continues to fund its own internal growth from internal
cash flow Capex for 2002 will be about $75 million. The company
should be able to finance this year and next with its operating
cash flow."6
Certainly it is true that the Cake has no debt, has not raised
capital from secondary offerings since 1997, and generates
significant cash flow available for Capex. What is less
understood, however, is the significant role that stock options
play in boosting CAKE's operating cash flow and cash on the
balance sheet.
SIDEBAR
Sell-side analysts covering CAKE applaud the company's apparent
ability to finance Capex internally from operating cash flow.
Accounting Treatment of the Tax Benefit of Stock Option Exercises
Under current tax rules, a company is allowed to claim a
compensation deduction on the income employees receive from
exercised stock options (i.e. the difference between the exercise
and market price of the option). That compensation deduction
reduces the income taxes paid by a company. Under Financial
Accounting Standards Board (FASB) rules, to the extent that a tax
benefit is realized, "the reduction of income taxes paid as a
result of the deduction triggered by employee exercise of stock
options should be classified as an operating cash flow." However,
companies are not required to break out the option tax benefits
in a separate line in the operating cash flow statement if they
elect to report the tax benefit in the statement of shareholders'
equity.7
While some of CAKE's competitors in the casual dining universe do
break out the option tax benefit in the operating section of the
cash flow statement (for example P.F. Changs, Buca, Applebee's,
Darden), CAKE has not. As a result, the role of option tax
benefits in CAKE's operating cash flow is not clearly evident.
SIDEBAR
In 2002, 27% of CAKE's operating cash flow was likely due to the
tax benefit of stock option exercises.
The Option Tax Benefit at CAKE
How important is the option tax benefit to CAKE's operating cash
flow? In 2002, 27% of CAKE's operating cash flow was likely due
to the tax benefit of stock option exercises. From 2000 through
2002, 18% of CAKE's operating cash flow was likely due to the tax
benefit of stock option exercises (see Table 4). Yet because
CAKE doesn't disclose the tax benefit in the operating cash
flow, it may be that few investors are aware of this fact.
Moreover, CAKE's operating cash is positively impacted from the
stock option tax benefit at a rate higher than CAKE's
competitors.
Table 4: Stock Option Tax Benefit on Operating Cash Flow
Is CAKE Self-Financing Capex?
If you strip out the impact of stock options on operating cash
flow, and subtract Capex (which includes expenditures for new
restaurants, upgrades, and maintenance), then it appears that
CAKE is not really financing all of Capex from recurring
operating cash flow. In 2002, CAKE actually had negative free
cash flow of over -$18 million (free cash flow defined as
operating cash flow minus stock option tax benefits and capex).
Since 1999, CAKE had negative free cash flow of nearly -$17
million (see Table 5). Without the tax benefits of the high
level of stock option exercises in 2001 and 2002, Capex could not
have been funded entirely from operating cash flow. In a sense,
CAKE financed some of the Capex by issuing equity to employees
through stock options.
Table 5: Free Cash Flow at CAKE
SIDEBAR
In a sense, CAKE financed some of the Capex by issuing equity to
employees through stock options.
Admittedly, CAKE generates strong operating cash flow available
to cover a large amount of Capex. However, it is clear that the
stock option tax benefits have contributed significantly to
CAKE's operating cash flow,allowing CAKE to fully self-finance
Capex. But these tax benefits are not necessarily recurring. If
CAKE's stock declines, stock option exercises will likely slow
down (because more options will be underwater), forcing CAKE to
find other sources of financing for Capex. Yet because CAKE does
not disclose the stock option tax benefit in the cash flow
statement, perhaps few investors are aware of this potential
risk. Accordingly, we believe CAKE should clearly disclose the
option tax benefit in the cash flow statement.
SIDEBAR
Because option tax benefits are not necessarily recurring, CAKE
should clearly disclose the benefit in the cash flow statement.
4. The Stock Option Impact on CAKE's Balance Sheet
At the end of 2002, CAKE had over $114 million of cash and
marketable securities on the balance sheet. Frequently, the
analyst community seems to suggest that much of the cash on
CAKE's balance sheet is coming from free cash flow generated from
operations. For example, Wedbush Morgan writes:
"The Cheesecake Factory ended the second quarter of 2002 with
$116 million in cash and investments, a $24 million increase over
December 2001. Cheesecake has steadily built balance sheet
strength as it has expanded. We expect cash levels to continue to
increase as we expect internal cash flow to more than cover this
year's $70-75 million and next year's estimated $80-85 million in
capital expenditures Free cash flow should continue to boost cash
on hand."9
However, it appears that a significant portion of the cash on the
balance sheet it due to stock option exercises and the associated
tax benefits.
Since the end of 1998, CAKE's cash has increased from $52.7
million to $114.5 million at the end of 2002, for an increase of
$61.8 million (of the $52.7 million on the balance sheet in 1998,
approximately $45 million was due to proceeds from the 1997
secondary stock offering). How has CAKE increased cash by $61.8
million?
First, as shown above in Table 5, if the $42.8 million of stock
option tax benefits are excluded from operating cash flow, CAKE
had a total of negative free cash flow of -$16.7 million since
1999. However, if the tax benefits are included in operating
cash flow, then CAKE shows about $26.1 million in positive free
cash flow. Thus, the stock option tax benefits account for 42%
of the $61.8 million gain in cash.
Second, from 1999 through 2002 CAKE has received $45.5 million
from the proceeds of stock option exercises (option holders
purchase the shares from CAKE when exercising options). If you
subtract the $12.9 million cost of CAKE's share repurchase
program, CAKE has netted nearly $29 million from stock option
exercises. Stock option exercises, and the associated tax
benefits, appear to account for at least $58.7 million of the
$61.8 million gain in cash on CAKE's balance sheet.
SIDEBAR
A significant portion of the cash on the balance sheet it due to
stock option exercises and the associated tax benefits.
Table 6: Stock Option Impact on Cash
5. No Shareholder Approval of a Key Stock Option Plan
Investors concerned about dilution at CAKE might be alarmed to
learn that shareholders have never approved one of the major
stock option plans at the company. On May 18, 1999--the date of
the 1999 annual meeting the CAKE Board of Directors adopted the
Year 2000 Performance Stock Option Plan without shareholder
approval. CAKE did not disclose the existence of the plan to
shareholders until nearly a year later, filing the plan as an
exhibit to a Registration Statement.10 Over the last 3 years,
CAKE's Board of Directors has steadily authorized shares for
grant under the plan from 300,000 shares in 1999 to over 5.3
million shares in 2002--all without shareholder approval.
CAKE was able to avoid shareholder approval by taking advantage
of the listing regulations of NASDAQ which do not require
approval of "broad based" stock option plans. However, reacting
to widespread criticism of the abuse of stock option plans,
NASDAQ has proposed requiring shareholder approval of most
option plans. The rules await final approval from the SEC.11
Given the substantial costs to shareholders, CAKE should submit
all stock option plans for shareholder approval, whether or not
NASDAQ requires shareholder approval. Because the Year 2000 plan
allows the Board of Directors to terminate the plan at any time,
CAKE could submit the plan for shareholder approval at the 2003
annual meeting.
SIDEBAR
Shareholders have never approved one of the major stock option
plans at the company.
6. The Stock Repurchase Plan That Keeps on Giving
Some CAKE investors may not be concerned about stock option
dilution because of the company's stock repurchase program. In
1999, CAKE increased its share repurchase program, announcing
that a "primary purpose of the Company's share repurchase program
is to minimize the dilutive effect of ongoing employee stock
option exercises."12 And some analysts apparently agreed. Kenny
Securities wrote in June, 2002 that "CAKE's share buyback program
has offset share dilution due to option issuance and solidified
EPS earnings gains."13
But the fine print of CAKE's financial statements suggests
something different. Since the announcement of the repurchase
program, CAKE has repurchased 1,047,300 shares as of October,
2002. According to company's SEC filings, those shares have been
repurchased "for reissuance upon the exercise of stock options
under the Company's current stock option plans." A review of
the company's registration statements shows that all of the
1,047,300 repurchased shares have been "reissued" as options
available for grant under the Year 2000 stock option plan--the
very plan that was not approved by shareholders.
SIDEBAR
All of CAKE's repurchased shares have been "reissued" as options
available for grant under the Year 2000 stock option plan.
Conclusion
For such a well-managed company with solid operating results,
CAKE illustrates the serious accounting and corporate governance
issues surrounding the use of stock options. CAKE could address
these issues by undertaking a number of voluntary actions,
including expensing stock options, submitting option plans
for shareholder approval, and improving disclosure of option
benefits in the financial statements.
However, we fear that CAKE's poor corporate governance practices
will hinder the company from seeking greater accountability to
shareholders on this issue. CAKE is protected by an arsenal of
anti-takeover devices, including a poison pill, a classified
board, and supermajority voting requirements--all which serve to
insulate the company from shareholders. With such a corporate
governance profile, it is unlikely that CAKE will address these
serious issues regarding stock options.
That's why we are asking shareholders to support our proposals at
the May, 2003 annual meeting urging CAKE to improve corporate
governance, expense stock options, and submit all option plans
for shareholder approval. More information is available at
www.ReformCakeGovernance.info
About the Culinary Workers Union 226/HERE
Culinary Workers Union 226, an affiliate of the Hotel Employees
and Restaurant Employees International Union (HERE), is a
shareholder of The Cheesecake Factory. In addition, a benefit
fund sponsored by the Culinary Workers Union is a holder of
25,900 CAKE shares. The Culinary Workers Union has a long
history of shareholder and investor activism in the gaming,
lodging, and food service industries. In addition, its parent,
HERE is a member of the Council of Institutional Investors, a $1
trillion coalition of public, union, and corporate pension funds.
The Culinary Workers Union, or affiliates of HERE, do not
represent any employees at CAKE. However, the Culinary Workers
Union has sought to organize employees at CAKE, and may continue
to do so.
Endnotes
1. "Corporate Governance in Crisis: Executive Pay/Stock Option
Overhang 2003," Watson Wyatt Worldwide, 2003.
2. All option data for The Cheesecake Factory, The California
Pizza Kitchen,and P.F. Changs derived from SEC filings.
3. "Accounting for Stock-Based Compensation," FASB.
4. Miller GAAP Guide, 2002.
5. "Q3 2002 Cheesecake Factory Earnings Conference Call Final,"
Fair Disclosure Wire, October 17, 2002.
6. "The Cheesecake Factory: Solid 3Q Up 34%; Maintain Market
Performer," Banc of America Securities," October 17, 2002.
7. "EITF 00-15," FASB Emerging Issues Task Force, July 20, 2000.
8. Not material or not disclosed.
9. "Casual Dining: From Luxury to Staple," Wedbush Morgan
Securities, September 26, 2002.
10. S-8 filed by The Cheesecake Factory on April 11, 2000.
11. "Alerts," Council of Institutional Investors, January 30,
2003.
12. "The Cheesecake Factory Announces Additional Lease Signings
and Increased Share Repurchase Authorization," PR Newswire,
December 13, 1999.
13. Kenny Securities, June 13, 2002.