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TEXAS ROADHOUSE – UPDATED WRITE-UP

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CONCLUSION

Texas Roadhouse is one of the premier operators in the space. Management is outstanding, their long term record is superb, and we don’t doubt that they will continue to be very profitable, will maintain a strong balance sheet, and show steady unit growth. At the same time, it is clear that even 4% traffic growth and 5.5% comps are not sufficient to overcome costs increases, and the menu increases to come could discourage at least a few customers. At 27-28x trailing 2018 EPS, and 24x the 2019 estimate of $2.55 (which might be a reach), the most recent quarter provided a vivid picture of how difficult it is to increase operating earnings. We therefore suspect that Q3 is a harbinger of mediocre results to come, and there could be a better buying opportunity at some time in the next 6-12 months.

COMPANY OVERVIEW (2017 10-K)

Texas Roadhouse is a growing restaurant company which operates three restaurant brands: Texas Roadhouse, Bubba’s 33 and Jaggers predominately in the Casual Dining segment. The first Texas Roadhouse opened in 1963 in Clarksville, Indiana. As of September 2018, they owned and operated 479 restaurants and franchised an additional 70 domestic restaurants and 21 international restaurants. Of the 479 restaurants, Texas Roadhouse operates 453 as Texas Roadhouse, 24 as Bubba’s 33 and 2 as Jaggers. Of the 91 franchised restaurants, the Company has a 5% to 10% ownership interest. The income derived from these minority interests is reported in the line item entitled “Equity income from investments in unconsolidated affiliates.”

Texas Roadhouse is a moderately priced, full-service Casual Dining concept which offers an assortment of specialty seasoned and aged steaks hand-cut daily on the premises and cooked to order over an open grill. In addition to steaks, Texas Roadhouse offers a selection of ribs, seafood, chicken, pork chops, pulled pork and vegetable plates, as well as an assortment of burgers, salads and sandwiches. The majority of their entrées include two made from scratch side items. All guests are treated to unlimited supplies of roasted in-shell peanuts and yeast rolls.

Texas Roadhouse’s mission statement is “Legendary Food; Legendary Service.” Their mascot is an armadillo named Andy. The Company restaurants and most franchisees offer entertainment in the form of line-dancing. The wait-staff and host perform these dances throughout the night. The employees also participate in annual intercompany competitions: bartenders compete in “Real Bar” competition and meat cutters in the “Meat Hero” competition.

The main selling entrée on the menu is the 11 oz. USDA Choice Sirloin.

Bubba’s 33 is a family friendly, sports restaurant concept featuring scratch-made food, ice cold beer and signature drinks. The menu features: burgers, pizza, and wings as well as a wide variety of appetizers, sandwiches and dinner entrées.

Jaggers is a Fast Casual concept that focuses on “fresh.” Fresh as in: ingredients, freshly made buns, fresh never frozen. The menu consists of sandwiches: chicken, burgers, pulled pork and fish. Jaggers also offers 4 types of salads and a broad variety of side items which include: Mac & Cheese, fries, tots, coleslaw, and edamame.

LONG-TERM GROWTH STRATEGY

Texas Roadhouse’s growth strategy is designed to position each of their concepts as a local hometown favorite for a broad segment of consumers seeking high quality, affordable meals served with friendly, attractive service.

The operating strategies that underline the growth of their concepts are built on the following key components:

  • Offering high quality, freshly prepared food –  They hand-cut all but one of their assortments of steaks and make all of their sides from scratch.
  • Performance based manager compensation – Texas Roadhouse offers a performance based compensation program to their individual restaurant managers and multi-restaurant operators who are called managing partners and market partners, respectively. Each of these partners earns a base salary plus a performance bonus which represents a percentage of their restaurant’s pre-tax income.
  • Focus on Dinner – In a high percentage of their restaurants, Texas Roadhouse limits the operating hours to dinner only during weekdays with approximately half of the restaurants offering lunch on Friday. By focusing on dinner, Texas Roadhouse’s teams have to prepare and manage only one shift per day during the week.
  • Offering attractive price points – They offer a choice of several price points with the goal of fulfilling each guests’ budget and value expectations.
  • Create a fun and comfortable atmosphere while maintaining high quality service focus – Texas Roadhouse believes that the service, quality and atmosphere they establish is a key component for fostering repeat business. They focus on keeping their table-to-serve ratios low to allow servers to truly focus on guests and serve their needs in a personal and individual manner.

OTHER LONG-TERM GROWTH STRATEGIES TO GROW EARNINGS

Texas Roadhouse’s long-term strategies, with respect to increasing net income and earnings per share along with creating shareholder value, include the following:

  • Expanding their restaurant base – Texas Roadhouse continually evaluates opportunities to develop restaurants in existing markets and in new domestic and international markets.
  • Maintaining and improving restaurant level performance – Texas Roadhouse plans to maintain or possibly improve restaurant level profitability through a combination of increasing comparable sales and managing operating costs.
  • Leveraging Texas Roadhouse’s infrastructure. Texas Roadhouse continually invests in their infrastructure to support, among other things, their growth. In recent years, some of these investments included information and accounting systems, real estate, human resources, legal, marketing, international and restaurant operations to include the development of the new Fast Casual concept, Jaggers.
  • Returning capital to shareholders – Texas Roadhouse continues to pay dividends and evaluate opportunities to return capital to their shareholders through stock repurchases.

SOURCES OF REVENUE (2017 10-K)

In 2017, total revenues were $2.2 billion; more than 99% of which was derived from sales of Company operated restaurants with the remainder from franchise fees and royalties. This was a 11.6% increase in 2017 compared to 2016 revenues. The following table summarizes certain key drivers and/or attributes of Texas Roadhouse restaurant sales. While we have not updated this table to reflect the first nine months of 2018, these numbers reflect the steady growth and consistently high volume restaurant performance within this excellent operator. The unit growth continues, the AUV’s continue to grow, the operating margins have recently been negatively affected by cost increases. As opposed to almost all other casual dining restaurant chains, traffic increases have been maintained.

UNIT LEVEL ECONOMICS (2017 10-K)

The Company does not separately break out the sales from Texas Roadhouse and Bubba’s 33. Therefore, the stated average unit volumes were $4,802,000. Alcoholic beverage sales accounted for 11% of sales in 2017.

The average total investment in a Texas Roadhouse was $5,250,000 with average costs for land of $1,265,000, building $2,170,000, FF&E $1,150,000 and pre-opening costs of $665,000.

Overall investment for a Bubba’s 33 restaurant was $6.1 million.

The current prototype for a Texas Roadhouse consists of a freestanding building with approximately 7,100 to 7,500 square feet of building space constructed on a site of approximately 1.7 to 2.0 acres. Seating of approximately 58 to 68 tables for a total of 270 to 280 guests including 18 bar seats and parking for approximately 160 vehicles.

Bubba’s 33 prototype is adaptable to in-line and end-cap locations. The prototype for Bubba’s 33 remains under development as they continue to open additional restaurants. They expect most future Bubba’s 33’s to range between 7,100 to 7,600 square feet and seating for 270 guests.

Texas Roadhouse’s management is focused on achieving an internal rate of return in the mid to high teens, in excess of its normalized cost of capital of 10-11%. Based on overall operating results for 2017, the average Texas Roadhouse was generating approximately $1 million in store-level earnings before interest, depreciation, amortization and rent, or a little under 20% of the cost to develop a restaurant. Store level margins were down 102 bp to 17.9% for the first nine months of 2018 and management indicated after Q3’18 that 18% is about as low as they like to see it. Menu price increases will presumably be implemented to keep store level margins above 18%.

Bubba’s 33 management is focusing on reducing the investment cost as it develops new locations. Bubba’s 33 has higher margins than a Texas Roadhouse primarily because of lower cost of sales so an internal rate of return in the mid to high teens can be achieved with a higher investment cost and similar sales volume.

The Company’s debt level is relatively low, with 9/30/18 year-end debt approximately 6% of shareholders’ equity.

 SHAREHOLDER RETURN (2017 10-K):

Texas Roadhouse has been one of the better performing Casual Dining restaurant stocks over the last five years, tripling since the fall of 2012, as EPS has grown steadily from $1.11 in calendar 2013 to $2.19 as the consensus estimate for 2018. The current dividend represents a 1.7% yield.

Repurchases of Securities: The most recent authorization was made 5/22/2014, for $100M. After purchasing 1,675,000 shares in 2014 (some of it under a prior authorization), 321,789 shares were bought in 2015, 114,700 shares in 2016, none in 2017 or the first nine months of 2018, and $69.9M remains. Since commencing their repurchase program in 2008, Texas Roadhouse has repurchased a total of 14,844,851 shares of common stock at a total cost of $216.6M.

RECENT DEVELOPMENTS (PER Q3’18 AND CONFERENCE CALL)

The third quarter of ’18 provided continued strong sales but lower operating margins. Comps were up 5.5% at company restaurants and 4.2% at franchised locations. Traffic was up an impressive 4.0%, price providing the balance of the comp gain. Restaurant EBITDA margin was down 157 bp to 16.2% as a result of higher labor costs, including insurance reserves. While diluted EPS was down 7% to $0.40/sh., Income Before Taxes (at 15.1% vs. 28.7%) was down a more meaningful 21.4%. Since nine month store level margin was down a more modest 102 bp and EPS was up 23.5%, the third quarter was clearly a deterioration from previous results. In Q3, three company restaurants opened, one international franchise. For nine months, 17 company stores, including four Bubba’s 33, were opened, plus four international franchised locations.

In terms of guidance for the remainder of 2018, management indicated that October had provided a comp of 4%, which was penalized by a point as it rolled over a post-hurricane lift a year ago. The full year 2018 was expected to result in “positive” comps (We would hope so, with 5.4% for nine months and 4% in October), no material change in previous expectations, basically a continuation of the nine month operational trends, though nothing specific was said about Q4 margins.

Looking to 2019, more of the same, with positive comps, 25-30 company openings including four Bubba’s, commodity cost inflation of 1-2%, wage inflation of mid single digits, and income tax rate of 14-15%.

On the conference call: a menu price increase of about 1.7% was planned for November, to offset the cost increases that affected Q3, and further price increases could be taken during early 2019. Average unit volume was up 4.8% in Q3, about in line with the comp, and the monthly sales trend was very consistent: 4.7%, 5.3% and 6.2% for July, August, and September. Cost of sales decreased 15 bp, other operating costs were down 22 bp. G&A increased 38 bp, but labor killed the income statement with a 194 bp increase to 33.5% of sales. Other line item variations were relatively small compared to the labor “giant in the room”. Cash generation remaining strong with $60M in Q3, spent as capex of $44M and dividends of $18M. The Company clearly doesn’t want to go heavily into debt to buy shares at this point.

In terms of store level margins: management indicated that 18% is a “feel good” number for them, so results below that, as in Q3, encourage them to think about raising prices. Bubba’s 33 continues to generate positive comps, up 6.5% through nine months, with two new prototypes to open in 2019.

Other than the above, the conference call consisted of discussion of quarter to quarter menu price increases in 2019, and the challenges of managing labor costs.

 CONCLUSION: Provided at the beginning of this article.

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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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