Texas Roadhouse Stock: Quality No Profit Business (TXRH)

Company description

Texas Roadhouse, Inc. (NASDAQ: TXRH) is a company that operates and franchises casual dining restaurants under the Texas Roadhouse, Bubba’s 33 and Jaggers brands in the United States and internationally.

Share price:

The share price of TXRH has performed extremely well over the past decade, consistently winning almost every year. This is due to the company’s ability to achieve what appears to be impressive growth in a sustainable manner. The company is taking market share away from larger competitors and establishing itself as a major player in the market.

Investment thesis

With the company’s current growth trajectory and share price performance, it is understandable that the company is building its prominence in the market. Our goal is to assess how attractive the underlying financials are compared to other restaurant participants, as well as look at what driving company growth and whether this is sustainable. This will help in valuing the company to gauge if there is any upside today.

Dining versus ordering

Eating

Consumer preferences for dining out have remained stable over the past few years, with an increasing number of consumers choosing casual dining as part of their social activities. This was evidenced by the initial post-pandemic period, with consumers actively choosing to return to dining at a level never seen before. With multiple delivery options and the convenience that comes with it, consumers are more selective when eating out and looking for a place that offers an attractive dining experience. With a focus on providing affordable food, our view is that TXRH is well positioned to take advantage of this. The company sells foods that don’t have the same value when eaten at home, such as steak, giving consumers a reason to eat. The company has proven this by seeing steady growth in customer dining despite weakening economic conditions and price changes.

Ordering

While nutrition remains stable, the real growth area is supplies. The COVID-19 pandemic has contributed to an increase in demand for home delivery options as many consumers see the value and convenience as an alternative to cooking. The biggest driver for this, however, is the rise in the number of delivery apps that bring together hundreds of restaurants and food businesses in one place for users to scroll through. This has changed the food industry as these businesses become the gatekeepers of consumer choice as they dictate the options consumers see and by virtue of where they choose to buy. TXRH is adapting to this trend by offering home delivery options as well as partnering with delivery services. However, as mentioned above, its menu does not naturally transition to delivery as many other cuisines do. That could slow the company’s demand compared to its fast-casual peers in the coming years as it rightly focuses on nutrition.

Expansion

Management continued to expand the company’s footprint with 23 new company restaurants and 7 new international franchises. In addition, TXRH acquired 8 local franchises (Source: Q4-22 reporting). This shows the company’s commitment to managing the restaurants themselves and how they see growth going in the coming years. This will be positive for sales next year as these locations grow to maturity. Comparable sales remain in the high single digits and so the company is likely to post net profits in FY23.

Inflationary pressures on spending

Economic conditions in the US are dictated by inflation, which has remained at a high level for more than a year. Much of this inflation stems from supply-side problems that have developed since the pandemic.

Labor costs are a significant expense for the restaurant industry and Texas Roadhouse is no exception. The company operates 86% of the total number of TXRH restaurants, giving them significantly more exposure than many of their franchise-operated peers. The company has implemented various strategies to reduce labor costs, including optimizing staffing levels and investing in automation. However, the company’s margins have been shrinking in recent periods.

In addition to wages, the cost of goods, including food and beverage prices, are also at elevated levels compared to previous years. Again, the company has tried to optimize where possible, but can only reduce the impact to a certain extent.

Restaurant margins fell 118 basis points in the year-to-date period as the company experienced 15.7% commodity inflation and 8.3% wage inflation. Our view is that pressures will begin to ease in FY23, allowing for margin expansion thereafter.

Demand easing

Another effect that inflation has is to dampen demand for many discretionary industries. This is because consumers are experiencing a contraction in their incomes as the cost of living increases. For these reasons, they find ways to cut costs. Restaurants are likely to be one of the industries hit hard, as home cooking / fast food tend to be cheaper options. This will inevitably impact TXRH’s revenue next year, primarily comparable restaurant sales, as top-line revenue will be positively impacted by new locations opened. Almost 70% of Americans said they are dining out less as a result of inflation, with 1/3 tipping less. This is a rapid turnaround from the initial post-lockdown period.

Our view is that this is likely to continue through most of 2023 as interest rates continue to help dampen inflation. Only until inflation falls below 4% will things begin to normalize and interest rates will begin to decline. This will likely mean a soft year for TXRH, with the potential for sales to decline if things slow down significantly.

Finance

Above are TXRH’s financials, which overall look extremely attractive.

TXRH grew revenue at a CAGR of 12%, driven by a growing number of restaurants and an improvement in comparable location sales. Arguably, the company is still finding its “mature” sales levels, with year-to-date comparable restaurant sales up 9-10% for both company-owned and franchise locations. Management forecast positive comparable location sales in FY23, with a 2.2% menu price increase introduced in March. This seems very conservative as the company has already seen a 15.8% increase in sales in the first 7 weeks of 2023, suggesting impressive resilience so far. Management probably believes that economic conditions will bite even more in the coming months.

As we discussed, the company is facing inflationary pressures which has contributed to the decline in GPM from 19% in FY19 to 17% in FY22. Our view is that this has the potential to go higher once commodity prices normalize, but is an ongoing risk to the business given its exposure to company-owned locations. Until then, management forecasts 5-6% commodity price inflation in 2023 and 5-6% wage inflation.

With the company growing at the rate it is, we’re not surprised to see S&A expenses grow in line with revenue. This cost includes share-based payments, marketing and pre-opening costs. These costs are likely to evolve in line with revenues over the medium term before declining.

In general, the financial indicators of the company are very attractive. Growth remains strong, but investors can enjoy an EBITDA margin of 11% and FCF conversion of 5%. They will allow the business to finance a consistent distribution of capital among shareholders.

Moving to the balance sheet, the company’s improving profitability is reflected in its return on equity, which has trended upward over the historical period. Management reinvestment in new locations is currently growing strongly. Management forecasts an additional 58-63 new locations next year.

Capital spending continues to rise as expansion is funded, with management forecasting an 8% increase next year.

TXRH is very conservatively funded, with little debt. Most of the “debt” is accounting debt reflecting leases. This allowed the company to maximize its distributions to shareholders, which it did through dividends and buybacks. Our view is that a slight reduction will be needed in FY23 as their cash balance has decreased, but should remain sustainable from then on.

Outlook

Above are analyst consensus estimates for TXRH’s performance over the next 5 years.

Sales are forecast to slow over the next 5 years, likely reflecting locations maturing and the greater burden on new restaurants. We agree with this view, as although the business is still expanding rapidly, it will not reach the levels of those in the fast-casual segment.

Interestingly, margin expansion is not considered possible beyond FCF. This is likely due to a lack of pricing power given the level of competition in the industry.

Restaurant industry

Presented above is a financial breakdown of a cohort of restaurant businesses.

What we are seeing is a superior performance of the franchise business, with TXRH falling to match their level of profitability. The company is growing faster on average, but this is not expected to continue.

Franchise businesses are primarily less risky as their franchisees bear the overhead risk and so based on current performance, TXRH should trade at a discount to competitors.

Valuation

The good news is that TXRH trades at a discount to the cohort we selected, but not to the extent necessary to be an attractive business today. We believe a 20% discount to the LTM peer EBITDA ratio is appropriate as it reflects the risk assumed and the lower yield. Based on this, we derive a fair value of 17x, implying a downside of 4%. This suggests a lack of growth at the moment, with analysts’ estimates suggesting something similar.

Final thoughts

TXRH is an attractive business. The company has grown on the back of quality food and good customer service. The dining experience will remain an integral part of society, but may not grow at the pace of the casual segment. Our view is that there are short-term headwinds ahead with economic conditions dampening demand. However, in the medium term, TXRH will be fine. The company’s profitability is attractive, but not compared to competitors. TXRH is not a bad business because of this, but we need to get the appropriate discount, otherwise it is more valuable to invest in similar companies. At its current valuation, we rate the stock as a hold.