TEXAS ROADHOUSE (“BEST OF BREED”) REPORTS Q2 – STOCK DOWN BIG – WHAT’S WRONG?

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TEXAS ROADHOUSE (“BEST OF BREED”) REPORTS Q2 – STOCK DOWN BIG – WHAT’S WRONG?

Readers are encouraged to read our descriptive report for broad background, presented here:

TEXAS ROADHOUSE

Last evening, after the market close, Texas Roadhouse reported their second quarter results. We consider TXRH among the best operators in the full service restaurant universe, with industry leading sales and traffic comparisons, consistent margins, bullet proof balance sheet, and a long term strategic focus.

The headlines included diluted earnings per share up 16.9%, comp sales up 5.7% at company restaurants and 3.9% at domestic franchise  restaurants. Most impressively, traffic was up 4.1%, almost unheard of these days. Also encouraging: comps in the first month of Q3 have been up 4.7%.  New store development has continued, with 14 company restaurants having opened in the last six months, 27-28 planned for the full year. Their Bubba’s 33 restaurants are also doing better, the twelve restaurants in the comp basis improving sales by 7.5%.

The most obvious issue is that almost the entire net earnings after tax gain was from an effective tax rate of 15.6% versus 27.9%  a year earlier. Restaurant operating margin decreased 77 basis points to 18.2%, primarily due to higher labor costs, very typical of almost every operator. Cost of sales actually declined 24 bp, atypical of most operators these days, due to higher average ticket.  In the wake of this more than acceptable report, the manic depressive money management community and computer driven traders reacted to the $.05 shortfall in estimated earnings  by adjusting the market value of TXRH by a cool $500M in the post 4:00 trades and almost $300M as this is written Tuesday morning.

The conference call should have been comforting since, from our vantage point, nothing has changed for the worse. Comp sales are expected to remain in the same range, commodity costs will rise by a relatively modest 1%, labor costs will continue to be rising by mid single digits, costing something like a point in operating margins, though continued traffic gains can mitigate that impact. New Roadhouse locations are averaging over $105,000 per week, and previous class years are showing overall returns well in excess of the weighted cost of capital. The Bubba’s 33 concept, with 20 locations at 12/31/17 plus 7 planned for ’18, is still being evaluated. New units, costing over $6M each, will be modestly smaller than in the past (just over 7,000 sq.ft.). Average AUVs at Bubba’s have not been disclosed.   While the contribution to corporate revenue from Bubba’s is material, it is still small relative to the much larger base of Roadhouses.

Most importantly, with very modest menu price increases over the last year or so, just over a point, we believe there is pricing power here to offset the inevitable increases in labor costs and the possible rise in volatile commodity costs. The operating culture here, so dependent on the long term retention of store level partners and their commitment to long term strategic values, seems capable of reacting better than most to operating challenges.

In summary: What has gone wrong at Texas Roadhouse? Virtually nothing. Investors can make up their own minds whether the short term reduction in share price is adequate to make this stock attractive at just over 25x ’18 EPS, especially since ’19 gains will not benefit from a further material reduction in the tax rate. The growth in revenues, profits, and cash flow may not be as rapid in the past but it will be more a function of industry wide issues  than management shortfalls.

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