Texas Roadhouse (NASDAQ:TXRH), a casual dining steakhouse chain, continues to be one of the best topline stories in the casual dining space. While the economic backdrop has improved, it would not be wrong to categorize the last five year as a difficult macro environment for the restaurant industry. Even in these difficult times, TXRH managed to grow its same store sales by 3.9% on average in the last five years, well above the Knapp-Track index of 0%, according to Credit Suisse (NYSE:CS).
TXRH has a dividend yield of 1.85%. The company pays out almost half of its earnings in dividend (payout ratio 48%). After paying dividend for the first time in 2011, the company has grown its dividend at a CAGR of 21%. It repurchased $43 million in stocks last year and has zero net debt. These factors combined with 7% unit growth, one would expect the company to grow report outsized growth in EPS. However, this has not been the case. Despite this disappointing earnings performance, TXRH is trading at a premium and I do not think it’s a good time to take position in the company.
What’s Driving TXRH’s Success?
TXRH managed to grow its same store sales by 3.9% on average in the last five years, well above the Knapp-Track index of 0%. Traffic has been even more impressive, averaging 2.2% over this 5-year period vs. Knapp-Track -1.9%. TXRH has one of the most loyal customer bases. In fact, according to a recent report by Morgan Stanley (NYSE:MS), TXRH, among its peers, is the most likely to be recommended by its customers. TXRH also boasts one of the best unit growth stories in casual dining, with consistent annual store growth in the ~7% range, helped by the company’s relatively small base of stores.
A number of other factors go in TXRH’s favor. The restaurants chain has simple menu with strong focus on quality ingredients and preparation. It relies little on marketing and innovation to drive sales. Finally it has an employee based that is fully engaged and properly incentivized. Most of the company’s stores are in the suburban, residential areas and lower energy prices are also contributing to TXRH’s success. While there hasn’t been a consistent correlation between gas prices and restaurant sales, the recent drop in gas prices occurred against the backdrop of improving economic condition and this has helped increased restaurants sales. As these lower gas prices continue to encourage additional restaurant visits, casual dining chains which target middle-income group should benefit the most.
Loyal Customer Base Over Price Hike
Following a slowdown during the post-crisis period (2009-2011), TXRH’s store rollout accelerated and is running at about 30 stores per year for the past 2 years. This represents about 7% unit growth. The restaurant chain has managed to grow its network while delivering industry leading SSS growth. The company’s network delivers a very strong AUV of $4.35 million. These store rollouts and healthy SSS growth has improved profitability but not as much as one would have expected. TXRH’s margins declined 90bps between 2010 and 2014 due to a 270bps increase in cost of sales ratio during the same period.
This shows that while food and labor costs are cutting into the TXRH’s profit margins, company has been reluctant to increase prices. Beef prices have been on the rise in recent years but TXRH has a tendency to underprice for this inflation, resulting in margins pressures. TXRH’s average check percustomer was $15.8 in 2013, compared to $20 of Outback, $19.00-$19.50 of LongHorn Steakhouse, and $19.70 of Cheesecake Factory (NASDAQ:CAKE). TXRH only modestly (1.8%) raised prices in November last year. Texas Roadhouse preferred to take a hit to its margins than risk alienating its value-added customers. According to Lynne Collier, an analyst at Sterne Agee CRT:
“TXRH was willing to absorb extra costs in return for better customer traffic. The company’s margins have been under pressure, but that was a sacrifice it was willing to make to generate more traffic. The company wants to establish this incredibly loyal customer base.”
Food cost inflation of 5.2% caused an increase of 84bps in cost of sales in the most recent quarter. However, the company expects food costs to ease and expects 3-4% full year inflation, implying at the lower end of range in the second half.
Economic Backdrop Improves But Valuation is High
The biggest target market for Texas Roadhouse and similar casual dining restaurants is the core middle-income consumer group. These restaurants tend to perform the best with the middle-income consumer group is feeling upbeat. As economic backdrop and consumer confidence continues to improve, it’s not surprising to see TXRH’s SSS accelerate in recent quarters. In the most recent quarter TXRH’s comparable restaurant sales increased 8.9% at company restaurants and 8.0% at franchise restaurant. However, the company failed to translate these healthy comps into strong EPS growth as the company’s decision to underprice for inflation adversely impacted margins.
This dynamic is likely to work again this year, with food inflation up 3-4% against about 1.8% pricing. Despite this modest earnings performance, TXRH valuation along with many of its peers in the restaurant sector inflated this year. TXRH is trading at a P/E of 27.7 compared to its 5-year average of 20.6. Similarly it is trading at a forward P/E of 22.2, compared to S&P 500 forward P/E of 18.6. TXRH’s P/B of 4.0 is also higher than its 5-year average of 2.6. Similarly, TXRH is trading at P/S of 1.6, which is higher than its 5-year average of 1.2.
Texas Roadhouse continues to be one of the best top-line stories in the casual dining space. There are a number of things to like about TXRH. It offers a simple menu with intense focus on quality ingredients and preparation. It has limited reliance on marketing and promotion to drive sales and it has an employee base that is fully engaged and properly incentivized. The company’s disciplined approach to growth also generates healthy free cash flow.
The company has managed to grow its SSS by more than 3.9% in the last 5 years. It has a loyal customer base and a high dividend yield. However, these healthy comps have not translated into outsized EPS growth due to margin pressures. Beef prices have been on the rise in recent years but TXRH has a tendency to underprice for inflation. Despite this somewhat disappointing earnings performance, the company’s valuation inflated in recent quarters and investors should wait for a better entry point.