COKE - Unraveling The Mystery: Why Texas Roadhouse Is Falling (Earnings Preview)

2023-10-23 09:00:00 ET

Summary

• Texas Roadhouse stock has underperformed the market this year, together with the whole industry.
• A recent proposal of the Department of Labor and the impact of weight loss drugs are worrying many investors.
• In this article, we unravel the mystery that is seeing a high-quality company falling, and we understand whether we may be before a buying opportunity.

Introduction

At the beginning of this year, I published an article explaining what led me, at the close of 2022, to buy my first shares of Texas Roadhouse (TXRH).

Since then, the stock has traded first all the way up to $115 and then it started pulling back so that I am in the green by only a couple of percentage points (not counting dividends).

However, though the stock has underperformed the market, I keep on being bullish. In this article, I would like to explain why while we make some forecasts about the upcoming earnings .

Summary of previous coverage

I first got interested in Texas Roadhouse because I found out a decorrelation with a leading restaurant company such as McDonald's (MCD).

When investors expect a recession, the stocks decouple significantly, with McDonald's representing a sort of safe-haven while Texas Roadhouse is usually perceived as more risky.

At first, I thought so, too. But the more I researched Texas Roadhouse, the less risky this company seemed to me.

In fact, I understood how it is highly customer-oriented , focusing on being perceived as the best restaurant where customers can find good value. This, per se, is a hidden asset. But it is part of how the economics of this company work and, as a result, it is an asset that generates constantly growing comparable sales, one of the main items to assess a restaurant.

When I looked more in depth at Texas Roadhouse financials, I didn't see anything that could make the company endangered even in case of a severe recession. We have seen how the company was resilient even during Covid, coming out of the pandemic stronger than ever.

This year, I was particularly impressed by the company's Q1 earnings, where I thought Texas Roadhouse "deliberately" missed (slightly) on earnings because its management made some right choices about capital allocation.

In fact, it would have taken only $250 million to bump up EPS so as to beat expectations. For a company that generated $190 million of free cash flow in the same quarter, it would have been rather easy to do so. But its management decided that, instead of spending this money on share repurchases while the share price was high, it was far better to pay down its long-term debt, making the company debt-free.

When I see a company carrying no debt, I admit it is the situation I prefer. True, there is good debt and bad debt, but carrying no debt is the safest and strongest situation a company can find itself in.

Why Texas Roadhouse (together with the whole industry) is selling off

So far, it is a story that becomes better and better. So, why has the stock been selling off since July? In addition, why has the stock pulled back this time together with McDonald's?

I think we can answer with another chart. It is intentionally crowded. We see the YtD % change of several stocks: in addition to Texas Roadhouse and McDonald's, I put Burger King owner Restaurant Brands International (QSR), Chipotle (CMG), Coca-Cola (COKE), Pepsi (PEP) and Hershey (HSY).

We could go on with many other similar stocks. What do they all have in common? They are mainly fast foods and casual dining restaurants or food and beverage producers.

So, what's wrong with food? Isn't this supposed to be an industry that won't ever go away?

Well, there have been two major concerns that have recently caused investors to shy away from the sector.

The first one was the proposal from the Department of Labor to restore and extend overtime protections for low-paid salaried workers. This rule would "guarantee overtime pay for most salaried workers earning less than $1,059 per week, about $55,000 per year". More in detail, the proposal aims at increasing the minimum salary threshold for an individual to be eligible for overtime pay to $55,068, up from the current $35,568 (a 55% increase). This could clearly impact retailers but the biggest potential impact is forecasted to clip margins for operators in the restaurant sector.

Concerned for the proposed rule, the National Restaurant Association issued a press release stating that "this rule will increase costs for affected restaurants by 2.5%. Adding this kind of cost to the already high price of food and years of increasing labor costs will leave many of these operators in the untenable position of raising prices, cutting costs, or closing their doors."

Though this could actually impact the whole industry, it is a proposal that could hurt more small business restaurants that don't have the scale of Texas Roadhouse and similar companies. Moreover, I think companies with such a strong franchise such as Texas Roadhouse and its peers mentioned above have enough pricing power to gradually offset higher costs.

More importantly, I think we are not factoring in the impact AI and machine learning could have on restaurants, streamlining menu preparation and reducing the need of workers. As the National Restaurant Association states in its " Restaurants 2030 Report ":

Technology and data allow for quicker consumer response, and restaurants will need to be nimble. Restaurants will need to embrace new ways of using data and information to keep up - or get left behind. Ordinary won't cut it in 2030. What constitutes a restaurant is rapidly changing. The off-premises market - carryout, delivery, drive-thru and mobile units - is where the majority of industry growth is going to come from over the next 10 years. But the only reason that growth can occur is that the technology is now in place to support it. Data-driven decisions will expand beyond sales and staffing applications to guest services, supply-chain logistics, and menu development, allowing restaurants to adapt what to sell in real time as demand dictates.

The same report believes "automation and robotics will begin to play a greater role in food preparation and the kitchen line". Therefore, staffing needs and compensation patterns might be very different from today, with operations having higher capital costs, but lower labor costs.

However, there is an even greater threat looming on the horizon and I think this is the real reason why Texas Roadhouse and the whole industry are selling off. It is linked to new weight loss drugs that are currently seeing a lot of success.

A few days ago, Walmart (WMT) gave a bit of a jolt to the industry saying that weight loss drugs are causing a "slight pullback" in terms of items purchased and total calories represented in purchases. This was something many investors were forecasting. A growing use of GLP-1 agonist drugs such as Novo Nordisk's Wegowy and Ozempic or Eli Lilly's Mounjaro is perceived as a fatal threat to the snacking and unhealthy food industry.

In other words, investors are fearing the end of snacking and casual dining.

Is this likely to happen, I ask myself? I don't believe so. As a matter of fact, we are talking about an industry that is the nation's second largest private sector employer , providing over 15.3 million jobs (around 10% of the total U.S. workforce). In addition, the industry, whose sales were $40 billion in 1970, is expected to top $1.2 trillion in sales by 2030, with more than 17 million workers.

On top of these things, it has been widely known by the industry that among the most likely developments by 2030, using the words of the Restaurants 2030 Report, "restaurants will offer more healthy options on their menus". However, the same report says one of the most likely development by 2030 is that "regardless of the nutritional content of the food, consumers will still want comfort foods". All of the above-mentioned companies have already poured a lot of effort into the development of sugar free or low-calory foods and beverages. If this is going to be the trend, I have no doubt Hershey or Coke or Pepsi or even McDonald's will simply accept to be put out of business. They will just come out with new products and menus, as they have done in the past.

But what I said above is linked to the general industry. Now, let's ask ourselves: is Texas Roadhouse rightly impacted by worries about weight loss drugs? Can it be considered together with every other unhealthy food restaurant?

Well, beef, if eaten too much, might not be the healthiest food. But neither is it unhealthy. Moreover, Texas Roadhouse offers a completely different dining experience from fast foods. These are more susceptible of seeing customers eating there obsessively. A Texas Roadhouse restaurant is not a place conceived as grab and go. It is a steak house, a place where to sit down and enjoy an evening with family members or friends. So, I view the company as one that doesn't simply throw out food to fulfill demand of hungry customers. It is also offering, together with its menus, an experience satisfying the demand consumers have for a pleasant dinner with others.

According to the National Restaurant Association "What's Hot 2023 Culinary Forecast", the top hop trend by category forecast, under dinner we find growing demand for less-expensive meat cuts, such as beef chuck and pork shoulder (together with chicken, of course). While many may think Texas Roadhouse could be hurt by this trend, we should also know that among the top 3 requests for the category of dinner there is "family meals". So, we have to consider that families still want to go out for dinner and are looking for places where they find the best value. Texas Roadhouse has made it is main focus to offer as much value as possible to its customers, instead of squeezing out of their pockets every possible penny.

Earnings preview

The Context

First of all, when dealing with restaurants we have to know which ones are the key measures used to evaluate a company.

The most important one is comparable restaurant sales, which reflects the change in sales for all restaurants of a certain company open for 18 months before he beginning of the measured period. This metric shows changes in guest traffic counts or changes in the average check amount per person.

Other useful metrics are average unit volume-representing the average annual restaurant sales-store weeks, new openings and, of course, restaurant margins. This last one is a non-GAAP measure widely used to evaluate.

At the end of Q2 2023, Texas Roadhouse reported solid earnings:

• revenue grew 14.3% thanks to an 8.7% increase of average unit volume and 5.6% store week growth.
• comparable sales were up 9.1%, driven by 4.7% traffic growth and 4.4% increase in average check.
• average weekly sales were up 8%
• restaurant margin dollars increased 8.3% but, as a percentage of restaurant and other sales, it decreased to 15.7%
• EPS were up 14.7%

Q3 Outlook

The company also shared its 2023 outlook, stating that during the first month of Q3, comparable sales increased 10.7% versus the prior year. It also updated its expectations, declaring it sees store week growth of 6%, 28 new restaurant openings, wage and labor inflation between 6% and 7% and capex of $300 million.

During the past earnings call , Jerry Morgan, the company's CEO, said "our guests continue to support our commitment to serving made from scratch food in a fun and friendly atmosphere", pointing out, once again, how Texas Roadhouse is not simply a place where to get some food to stave off or appease hunger. After all, according to a recent YouGov survey on Q3 2023 most popular dining brands, Texas Roadhouse comes in sixth place among millennials and is the first among casual dining restaurants, seeing in the first 5 positions brands that don't really compete with it: Burger King, Cinnabon, Subway, McDonald's, Baskin-Robbins.

This was clearly said during the last earnings call:

we continue to see strong consumer demand to come to Texas Roadhouse. The mix kind of trends have continued, where we're seeing some alcohol negative mix and the rest is coming from the entree category.

And with the strong guest counts that we're seeing, it would appear to us that we are seeing people trading into Texas Roadhouse, but the value side of the menu, there could be certainly some people who are doing some check management as well and are trading down our menu.

Q3 Estimates

Texas Roadhouse usually takes pricing decisions in October. Therefore, Q3 results should not have any particular surprise in terms of revenues, unless guest traffic suddenly diminished. We do know, in any case, from the past earnings call, that pricing for Q3 will be 5.1%.

Considering that commodity costs have been in line with the company's expectations all year long, we can make some estimates about what would be a good report.

We already know the data for the first month of the quarter: 10.7% increase in comparable sales. This means that they are growing not only because of pricing, which is at 5.1%, but also because of increased traffic or increased average check. Since Texas Roadhouse has already talked about signs of a little check management, I believe most of the comp sales increase is linked to increased traffic.

Currently, analysts estimate a quarterly revenue of $1.12 billion (+12.9% YoY) and EPS of $1.06. Usually, Q3 is a bit slower compared to other quarters due to summer holidays, which lead many people to travel or move from home. Texas Roadhouse, as said, it is mainly an experience linked to families and friends.

I expect a 12% growth in total revenue. In fact, while the economy is slowing down a bit, not every sector is equally impacted. High interest rates are not hurting consumer income, but only financing activities. Therefore, while car or home sales are becoming more difficult, consumers still have high incomes to go and eat out. Actually, with consumers taking less loans, there monthly income will increase for some time. I see restaurants as a go to choice because of this.

This is why my expectation is to see Texas Roadhouse post $1.11 billion in revenue. Considering expenses are in line with the company's performance, we can expect a net income margin of 6.7% . This leads to $74.4 million in net income. Dividend by the 66.8 million of common shares outstanding, EPS should be $1.11, a bit above the current forecast.

To tell the truth, I expect the company to have done some buybacks because of the depressed share price, so this estimate could be revised a little upwards, depending on the number of outstanding shares the company will report during the release. Last year, during Q3, the company increased its share repurchases, buying over 1 million shares during the quarter, returning $84.7 million to its shareholders. I believe it has done so this year, too.

Assuming the company repurchased around 1 million shares, the forecasted EPS would go up to $1.13, which is a 6.6% increase vs. estimates. This means the company could be trading at fwd PE slightly below the current 20.6 which is rather low compared to the company's usual multiple.

At the moment, I have no doubt. Texas Roadhouse is a buy going into earnings and in case of a miss and a drop in price, it will be one of the stocks whose shares I will scoop more intensively.

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