One of my favorite sectors as an investor is the restaurant industry. During my last trip to the US in 2019 I went to Texas Roadhouse (NASDAQ:TXRH) and I enjoyed my dinner. The steak was delicious, the rolls were excellent, and the waitstaff was friendly. Since I only had the opportunity to visit once, I did some online research to gauge overall customer satisfaction and I must admit that most of the reviews for this chain restaurant are good, I leave here below some of them:
Last summer my son and I each had a salad, steak and baked potato and we shared some fried mushrooms. We liked it and would go back.
I always get a tenderloin and have never had a bad one. Their ribeye is good also, and if you want you can choose your own steak from the meat case and their hot rolls are good too!
It's my family's favorite affordable steak house. The sirloin is tender as heck, the hot rolls melt in your mouth, and the ribs are delicious. Compared to other similar priced places, I highly prefer Texas Roadhouse.
What I like the most about the company is that, in contrast with other restaurant chains that prioritize numbers and margins, Texas Roadhouse's managers remain more focused on customer experience and product quality. It reminds me a little bit of the story of Steve Jobs, who was super-focused on product quality and innovation at Apple (AAPL) more than numbers and financial performance. Overall, this strategy leads to better results and creates a better long-term opportunity for corporations. However, I highlight potential issues on the side of franchise costs when comparing it to the cost of its peers. Moreover, the current valuation is a little bit too high, and I would prefer to see a drop in stock price before opening a new position in this stock, that is why I rate it a "hold".
I will begin with a stock price overview, I will quickly analyze the business and the financial data considering the recently released Q4 2023 earnings, analyze in detail the risk related to franchise costs, and finally conclude with a valuation.
Stock Price Overview
Over the last 15 years, TXRH outperformed the S&P 500, growing more than 760% while the index appreciated only 290%. It is not that frequent to find a company growing more than the S&P 500 when not taking into account major players like the FAANG stocks. In my opinion, the company is well-positioned to continue growing at a good pace, delivering favorable returns for its shareholders also in the future.
Company's Business Overview
The company owns and manages three different restaurants:
- Texas Roadhouse: a casual dining restaurant specializing in steaks, ribs, and various kinds of meat such as chicken, pulled pork, and hamburgers. At the end of the 2023 fiscal year, the company had 727 Texas Roadhouse restaurants available in the US and 10 other foreign countries.
- Bubba's 33: a restaurant chain that offers a menu slightly different from Texas Roadhouse, including burgers, pizza, wings, and a wide variety of appetizers.
- Jaggers: a fast-casual restaurant concept mainly focused on chicken and burgers, the restaurant is also famous for its house-made sauces.
The operating strategy is completely focused on providing an exceptional customer experience, and it can be summarized through three main pillars:
- The company offers high-quality, freshly prepared food;
- The restaurant's atmosphere is fun and comfortable, and the managers are focused on high-quality service;
- The company offers attractive price points and evaluates menu pricing carefully to balance possible short-term pressure with long-term growth.
I appreciate the fact that, as reported during the Q3 2023 conference call, the company's CEO and other executives tour more than 700 operators from all three concepts each year. This tour allows senior managers to interact directly with managing partners, understanding potential issues or new ideas to integrate into the business. As I read this the first time, I remained astonished by the level of commitment managers demonstrate towards the products they sell and customer satisfaction. I would be pleased to witness a continuation of this trend also in the future. However, I would consider downgrading the stock if the company starts neglecting these crucial metrics.
Overall, I consider the restaurant industry to be a cyclical one. Even though someone could argue that food is a constant necessity and people will always need to eat, as I discussed in my first article about PepsiCo (PEP), restaurants, particularly non-fast-food establishments, tend to be more tied to economic cycles.
Financial Data
Since 2016 the company has grown revenue at an 11.13% compound annual growth rate, expanding consistently every year except for 2020 which was impacted by the pandemic. Despite the challenges, the company demonstrated resilience in the face of difficulties, reporting a positive net income also in 2020. In general, net income grew at a higher pace than revenues, around 12.90% CAGR in the same period.
In Q4 2023, the company grew its revenue by 15.3% and diluted earnings per share increased by 21.4%. As a consequence of a higher growth of net income than revenues, the net margin has slightly improved over the years, as illustrated in the graph below.
I expect the company to continue growing revenues by around 10%-15% yearly for the next 3 to 5 years and the net margin to slowly improve up to 10%.
The short-term debt situation is a cause for concern. The company maintained a current ratio fluctuating between 0.6 and 1, which is an ideal situation, meaning that the company has pricing power among its suppliers and can efficiently manage its working capital. However, the last report shows the company in a situation in which it has only 48% of its current assets able to cover its current liabilities. I expect the company to raise its long-term debt to cover this issue.
The total debt has been on the rise over the years but remains in a favorable situation. It is currently at a little bit more than 4 times the company's free cash flow. This healthy ratio suggests that the company is well-positioned to leverage its financial standing for further growth, eventually with new acquisitions.
The cash flow from operations has been increasing at a good pace, mainly driven by an expansion of operations. Even though the increase in capital expenditures has been huge to sustain the growth, the company was able to successfully manage these costs and report also a steady increase in the free cash flow. Over the years, I would like to see an improvement in the free cash flow figure, mainly driven by an increase in revenue and a better margin level.
The free cash flow is used to reward shareholders through dividends and share buybacks. The company is also focused on dividend increases to deliver long-term value to its shareholders. In 2023, the company returned over $147 million in the form of dividends and completed $50 million of share repurchases.
Growth Opportunity
The company expansion strategy, primarily through a franchise formula, closely aligns with the strategy adopted by its main competitors, McDonald's (MCD), KFC (YUM), etc. I think it is the best way to expand rapidly, maintaining a tight balance sheet. The company is predominantly present in the US and has only 10 restaurants abroad. In the coming years, I expect the company to continue growing both in the US and in foreign countries, with a particular focus on reaching the milestone of opening 1000 restaurants. This ambitious goal aims to strengthen its competitive position against rivals.
From an international point of view, restaurants today are mainly available in the Asia Pacific and Middle East regions. I expect the company to expand more in Europe than in Asia and the Middle East in the future, and generally to have a balanced approach to international expansion. This strategic approach allows the company to be more flexible among dynamic economic conditions that may arise and to be better positioned to leverage regional consumer preferences.
In the last nine years, the company increased the number of stores at a 4.8% CAGR. Considering the general growth forecasted for the restaurant sector and the fact that the company is still in its early stages, I expect it to be able to grow at the same pace also in the future.
Risks
In addition to classical risks extensively explained by the corporation in its financial report (p. 13-15 of 10-K), I would like to address what, in my opinion, is the biggest risk that can hinder future growth: franchise costs.
As the company is aggressively pursuing expansion, the franchise strategy is the most viable, as discussed previously. However, the franchise costs are too high when compared to those of competitors, potentially making the company less attractive to small entrepreneurs considering opening a new restaurant. I did research online, consulting different sources, and this is a summary of my findings.
Starbucks (SBUX):
Liquid capital: NA
Franchise fee: NA
Total investment: $228,620 to $2,888,700
KFC:
Liquid capital: $750,000
Franchise fee: $45,000
Total investment: $1,000,000 to $2,700,000
McDonald's:
Liquid capital: $500,000
Franchise fee: $45,000
Total investment: $1,370,000 to $2,450,000
Burger King (QSR):
Liquid capital: $500,000
Franchise fee: $50,000
Total investment: $1,790,000 to $4,190,000
Texas Roadhouse:
Liquid capital: $200,000
Franchise fee: $40,000
Total investment: $4,822,000 (mid-point)
As we can notice from the data reported above, the total investment required for a Texas Roadhouse restaurant from a franchisee surpasses that of other competitors significantly. I believe that in the long run, this difference in costs may limit the pace of growth as the company will struggle to find new franchisees. To better explain this point, I provide you an example. Consider an entrepreneur who wants to open a new restaurant using the franchise formula, the initial step would likely involve an internet search to understand the associated costs and determine affordability. Among the list presented above, it is straightforward to understand that Texas Roadhouse will immediately be excluded. Why would an individual invest such a substantial amount when they could open a new McDonald's restaurant for less than half the price? Moreover, McDonald's and the other chains can also be considered more secure and potentially more profitable than Texas Roadhouse.
I believe that the company should find a more competitive and attractive franchise model to sustain its current growth rates also in the future.
Valuation
Since the company has both a positive free cash flow and a good commitment to dividends, I decided to evaluate it through either a dividend discount model, and a discounted cash flow model.
Beginning from the former, as we can see from the picture below, on the right side I computed the annual dividends of the last five years and the relative growth rates. On the left side of the sheet I reported the expected dividends for fiscal year 2024, considering an annual market return of around 15% to be conservative, and a future expected dividend growth rate of around 12%, I obtained a fair value per share of $91.
The situation is a bit better when considering the free cash flow. On the upper side of the sheet, I computed the cost of equity assuming a 4.5% risk-free rate, the company's beta equal to 0.97, and a market return again equal to 15% to be conservative. The cost of equity obtained is equal to 14.68%, and I used it as a discount factor. I decided to project 2023 free cash flow with a 10% growth until 2026, and an 8% growth until 2028. I also assumed a terminal value equal to 3%. The FCF growth rates reflect my thesis on the company's growth opportunities and possible margin expansion. I finally obtained a fair value of $121.67 per share.
In both cases, the numbers obtained are lower than the current price, especially if we consider the rise after the earnings call, meaning that the company is potentially overvalued. However, the company has interesting growth opportunities ahead, and I will patiently wait for a stock price drop to open a new long-term position.
Conclusion
Texas Roadhouse is a wonderful company with an incredible possibility for future expansion. Despite some uncertainties concerning the franchise costs, I am optimistic about its future and I would like to initiate a long-term position. However, as it usually happens in these situations, the company's price is too high, and I would suggest waiting for a price retracement before considering buying new shares.
Niccolo Braccini
I focus on long-term growth and dividend growth investing. I follow the US and the European stock markets, looking for undervalued stock and high-quality dividend-growing companies that provide me with cash to reinvest.I hold a Business Management degree and am pursuing a Master's degree in Finance and Risk Management in Italy.Upon completing my studies, I aspire to work in the financial sector, specifically aiming for a role as a financial analyst. I believe that Seeking Alpha can provide me with the opportunity to gain practical experience and help people understand my investment rationale.
Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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