After doing a better-than-bad job on Texas Roadhouse in 2011, we did not have a view on the stock coming into 1Q12 earnings and missed a sizeable pop in the share price. On the category more broadly, we have held a cautious-to-negative view since our 4/20/12 note, “CASUAL DINING CAUTION”.
Over the intermediate-to-long term, our bearish stance is dictated by slowing demographic trends and a difficult macroeconomic outlook. Casual dining has not underperformed the market since our 4/20 note but we believe the heightened volatility in the group has been worth avoiding. On the positive side, Brinker, a long-time favorite of ours, has managed to sustain a relatively smooth upward trajectory over the same time period and remains our favorite stock in casual dining.
While our caution on casual dining was a couple of months premature, we remain bearish today as several factors are serving as headwinds for the group. We detail those factors below.
Demographics: Before he exchanged un-pleasantries with his shareholders, CEO Clarence Otis spoke about Darden and casual dining’s position within the restaurant industry. The declining number of baby boomers with high levels of disposable income, and the headwind that that represents for restaurant chains that are not adapting to the preferences of the increasingly Millennial-dominated consumer base. This is a negative for all companies in casual dining that are supporting concepts that are struggling to stay relevant.
Labor Market: The U.S. economy is, from a growth perspective, on life support as Federal Reserve interventions continue amidst much-less-than-satisfactory jobs growth.
Gasoline Prices: Gasoline prices are above 2008 levels and 16% higher than they were on June 30th. We believe that this poses a significant risk to continued growth in the economy. Given the discretionary nature of expenditure at casual dining restaurants, the corollary to this is a negative view on the category’s share of the consumer’s wallet.
Casual Dining Conclusion: As the group deals with adverse demographic and macroeconomic factors in the near-, intermediate-, and long-term, investors will likely seek out companies that are taking share and differentiating themselves from the herd in what has become a heavily-oversupplied industry.
Specific to Texas Roadhouse, beyond the issues facing the category, we see the following issues as important for investors:
- Food Inflation
- Highly Competitive Sub-Category
- New Unit Volumes and Returns
At this point we would advise clients to avoid TXRH on the long side. The charts and text below elaborate on our thoughts specific to the company.
Earnings Revisions and Sales Trends:
We do not expect earnings estimates to rise from here as beef inflation accelerates and same-restaurant sales bump up against difficult weather compares. Bloomin’ Brands coming public (and putting Outback Steakhouse’s best foot forward) is increasing discounting at a time when the Restaurant Value Spread (CPI Food at Home less CPI Food Away From Home) is negative and declining further, lessening the pricing power of restaurants within the food complex.
Capital Spending Accelerating Far In Excess of Sales Growth
One of the red flags in our assessment of the sustainability of Texas Roadhouse’s growth trajectory is a sustained period of capital expenditure growth unaccompanied by commensurate sales growth. In 2011, the company took a decision to restart unit growth and the company has now seen capital spending grow faster than revenues for six straight quarters. Importantly, as of last quarter management is saying that the new units are not performing as well as the broader unit base. On the 2Q call, Texas Roadhouse CFO Price Cooper said, “While our newer restaurants continue to open strong, as they move through the honeymoon period and their sales normalize, their base is slightly less than existing restaurants.” We believe that there is risk to the stock’s multiple if returns decline.
The Stock Price Should Trend In-line with Returns
The net result of the bifurcation between capital spending growth and sales growth is declining returns on incremental invested capital. Our view is that, from a shareholder perspective, tying unit growth to a more conservative expectation of sales growth and returning surplus cash to shareholders would be a more attractive strategy.
Accelerating Food Costs Are Presenting a Challenge For Margins
There is a no relief in sight for the company when it comes to higher beef prices. Over the past couple of quarters, the company has been able to manage labor costs, but slowing sales and industry headwinds are likely to exacerbate the impact of rising food costs. Our expectation from here is for restaurant level margins to decline under pressure from rising input costs and a difficult top line environment.
Beef is a significant driver of input cost inflation for TXRH. In March, the company had the following to say:
“Now, the not-so-good stuff-food inflation up approximately 8%. That's primarily beef driven and most of you probably are aware of that. There has been significant inflation in the beef markets, live cattle markets. I suspect that'll be little a bit continued in 2013 until herds get rebuilt of cattle, so we may have to bear with that for a while and we will.”
We expect beef prices to remain elevated as herd sizes are depleted and will likely take several years to rebuild. From a pricing standpoint, for a couple of reasons, we believe it may be difficult for Texas Roadhouse to take additional pricing to protect margin. First, competition in the steak category is fierce with Outback in the public arena once again and non-traditional competitors like Chili’s launching steak at their restaurants. Secondly, while Texas Roadhouse likely does not compete with grocery as directly as some other casual diners, the Restaurant Value Spread (CPI FAH less CPI FAFH) is indicating that traffic in casual dining, as measured by Malcolm Knapp, is likely to decelerate over the next six months or so. For TXRH, the chart below seems to indicate that a sequential slowing of comps is possible as consumers encounter less inflation in the grocery aisle than at the restaurant.
The Stock’s Valution is Cheap, Probably for a Reason
TXRH is being touted as “cheap” by some in the investment community but, as is the risk with valuation, estimates may be overly bullish as sales slow and inflation accelerates.