Texas Roadhouse (TXRH): An Impressive Dividend Grower in a Tough Industry

Restaurants can be a potentially great but also very challenging industry for dividend growth investors to do well in.

 

After all, a steady expansion of store counts can lead to highly predictable growth.

 

But on the other hand, a ruthlessly competitive environment, shifting consumer tastes, and numerous cost uncertainties can make it challenging for restaurants to generate the kind of strong margins, earnings, and cash flow that typically back safe and steadily-rising dividends.

 

Texas Roadhouse (TXRH) is one of the few national chains that is flourishing in a highly challenging industry environment, which has allowed the fast-growing company to generate impressive six-year dividend growth of 17.5% per year.

 

Let’s take a look at the secret sauce behind Texas Roadhouse’s success so far. More importantly, find out whether or not the chain is likely to be able to keep its winning streak alive in the long-term and if today could be a good time to add this restaurant chain to a diversified dividend portfolio.

 

Business Overview

Founded in 1993 by Kent Taylor (founder, Chairman, and CEO), in Clarksville, Indiana, Texas Roadhouse is a national chain of casual dining restaurants operating 540 stores in 49 states and four foreign countries. The chain has a Texas roadhouse theme and is known for its affordable steaks, ribs, and complimentary bread.

 

455 of its stores (84%) are company-owned and operated, while 95 are franchises. The company has recently diversified into a new concept, Bubba 33, a chain of sports bars. Overall, 99.2% of revenue is derived from restaurant sales with the remainder coming from franchise fees.

 

Business Analysis

The restaurant industry as a whole has seen great success over the past decades as consumers have increasingly preferred eating out over cooking at home.

 

 

Of course just because the industry as a whole has thrived doesn’t mean that it’s easy for every restaurant chain to grow quickly or profitably. In fact, in the recent 2016-17 restaurant recession, characterized by declining same store sales (locations open at least a year), a number of industry players have faced strong growth headwinds.

 

 

Texas Roadhouse has done an admirable job of bucking this trend with strong comps growth over the past few quarters, including 4.5% and 4.7% Q3 2017 same store sales growth in its company-operated and franchised locations, respectively.

 

 

Better yet, in its most recent conference call, management forecasted 5.3% comps growth in Q4 2017, thanks to both strong growth in foot traffic (over 3.5%) as well as rising average meal prices.

 

What’s the secret to Texas Roadhouse’s success? That can largely be explained by the company’s strong emphasis on its core principles, which break down to three main factors.

 

First, Texas Roadhouse prides itself on large portions of good food (hand-cut steaks, made-from-scratch sides, and freshly-baked bread) at affordable prices. Next, the Texas theme makes for a fun atmosphere, with a strong focus on experiences such as in-store line dancing and a very friendly staff.

 

In addition, management of stores has a lot of leeway when it comes to operations, with relatively little micromanagement from headquarters. The company uses a unique performance-based compensation model that shares a portion of a restaurant’s profits with its general manager.

 

Specifically, the company notes that managing partners and market partners “are required, as a condition of employment, to sign a multi‑year employment agreement. The annual compensation of our managing partners and market partners includes a base salary plus a percentage of the pre‑tax net income of the restaurant(s) they operate or supervise. Managing partners and market partners are eligible to participate in our equity incentive plan and, as a general rule, are required to make deposits of $25,000 and $50,000, respectively. Generally, the deposits are refunded after five years of service.”

 

This policy engenders greater levels of service and employee loyalty while providing store-level management with the opportunity to make significantly more than they would working at other restaurants that simply have a set salary.

 

While still small and thus posting below average profitability relative to larger rivals (who enjoy greater economies of scale), the company has also done a good job of minimizing general and administrative costs. This is in large part due to the leadership of founder and CEO Kent Taylor, who owns 5.8% of the shares and has a strong incentive to run a tight and lean operation.

 

Texas Roadhouse Trailing 12-Month Profitability

 

Meanwhile, costs at the store levels have been kept in line by a relatively fixed menu, one that doesn’t require constant updating and discounting of failed new food items.

 

In other words, Texas Roadhouse has hit upon a popular niche and has been highly disciplined in how quickly it grows. For example, many restaurants will take on a lot of debt to expand as quickly as possible. That’s why the industry’s average leverage ratio (more on this later) is so high.

 

Texas Roadhouse, on the other hand, has been very conservative with debt and chosen to grow its business organically, funding mostly company-owned store expansion through retained free cash flow. This allows it to better control its brand and ensure a more consistent customer experience.

 

 

The company’s strategy has been working beautifully, with industry-leading growth in its top and bottom lines, as well as consistently rising returns on capital as its economies of scale increase.

 

 

Management expects to open 26 to 27 new locations in 2017, and about 30 in 2018, including 7 Bubba 33’s, its new sports bar concept. While it initially costs more to open a sports bar, the lower cost of food, plus the increased consumption of high-margin alcohol, means that these locations are generally more profitable for the company.

 

The bottom line is that Texas Roadhouse appears to have carved out an excellent position within its niche, one that seems to offer strong long-term opportunities for continued sales, earnings, and dividend growth. However, that doesn’t mean the restaurant chain will be able to avoid major pitfalls in the future.

 

Key Risks

While Texas Roadhouse’s strong growth during a restaurant recession has been impressive, investors need to realize that this is still a high risk industry in which to invest.

 

This is because there are numerous factors affecting the company’s short-term earnings and cash flow (and thus dividend) growth that management has little to no control over.

 

For example, about 80 of its restaurants are in states that are mandating much higher minimum wages (up to $15 per hour), which is resulting in labor costs rising about 16% this year in those locations. Company-wide, that translates to about 8% increased labor costs in the most recent quarter.

 

Next year, management expects mid-single-digits labor cost increases as well and will have to rely on continued strong comps growth in order avoid having to raise its prices and thus undercut its historical “big portions at reasonable prices” appeal.

 

That in turn means that Texas Roadhouse’s same store traffic growth will need to remain strong in order to keep pricing increases to about 1% in 2018, which is what management is targeting to avoid shocking its traditionally value-focused customer base.

 

Another problem for the company is that in 2017 it benefitted from lower food prices (lower beef prices lowered food costs 2% this year). However, that can’t be expected to occur every year. After all, food prices are cyclical, and in fact management expects 2018 food costs to be flat.

 

In the future, when volatile beef prices eventually increase, the company is likely to face a prolonged growth headwind, created by steadily rising labor costs (minimum wage hikes are being phased in over several years) and the inevitable spike in input costs.

 

In fact, wholesale food prices have recently begun trending strongly higher, which means that Texas Roadhouse may face lower profitability than expected in 2018. For now, management will continue relying on the multi-year contracts the company typically enters with its beef suppliers to attempt to minimize input cost volatility.

 

 

Of course, should Texas Roadhouse achieve sufficient economies of scale, that could also help to mitigate these input price uncertainties through a larger and more efficient supply chain. However, there too there is no guarantee that the company can continue achieving its impressive historical success.

 

After all, the Texas Roadhouse concept is one that is hardly unique and likely to have a natural limit on how many stores it can support. This is both because steak houses and casual dining restaurants are a highly saturated and competitive industry in this country. For example, in 2016 there were nearly 621,000 restaurants in the US.

 

70% of those restaurants are single-store concepts because it’s notoriously difficult to achieve success in an industry with a three-year failure rate of 59%. This is because each individual restaurant’s success depends on its location and being able to cater to localized taste from sufficiently affluent consumers.

 

However, in recent years consumer tastes have been shifting away from the “meat and potatoes” kind of offerings that Texas Roadhouse specializes in and more towards a focus on healthier and more sustainable lifestyles. For example, recent surveys have shown that:

• 40% of consumers say that special dietary needs are important to them when choosing a restaurant
• 60% of consumers indicated that “environmentally friendly food” is important to them
• 63% of Millennials are eating more ethnic food

And while it’s true that Bubba 33 appears to be a flourishing (and higher margin) concept than its name brand restaurants, there too Roadhouse faces major challenges, as sports bars are a heavily competitive industry where success is often highly localized and difficult to replicate.

 

This is why the company has such a strong (and smart) emphasis on high levels of management autonomy, to allow each store manager or franchisee to adapt to what local customers demand. However, that also means that Texas Roadhouse is forced to grow in a highly disciplined manner, making sure to not open too many new locations without first finding the right people to successfully operate them.

 

In other words, it’s possible that the current rate of about 30 store openings a year will continue, since it’s worked so well for a management team that is all about quality over quantity and to whom protecting the brand’s culture is very important. However, that could mean that investors will have to settle for slower and more volatile growth than in the past. That’s especially true if foot traffic and comps ever fall off their industry-leading levels and make it much more challenging to deal with volatile but generally rising labor and food expenses.

 

Of course we also can’t forget that the restaurant industry, especially casual dining like Texas Roadhouse, is highly reliant on a strong economy. This means  that its sales and earnings are cyclical and decline during a recession when consumers spend less.

 

During The Great Recession, Texas Roadhouse managed to continue growing, but only because it was a far smaller company and thus able to drive overall sales and profit growth through new store openings. With a much slower pace of new store openings (as a percentage of its larger installed base today), investors can’t expect the same thing to necessarily hold true during the next economic downturn.

 

Combined with the capital intensive nature of opening, maintaining, and upgrading individual locations, this can cause earnings and free cash flow to be volatile and make it much harder for companies to maintain safe and growing dividends over time. However, that’s not to say that Texas Roadhouse’s dividend isn’t safe, because there are several positive factors that make it among the safest in its industry.

 

Texas Roadhouse’s Dividend Safety

We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend.

 

Our Dividend Safety Score answers the question, “Is the current dividend payment safe?” We look at some of the most important financial factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more.

 

Dividend Safety Scores range from 0 to 100, and conservative dividend investors should stick with firms that score at least 60. Since tracking the data, companies cutting their dividends had an average Dividend Safety Score below 20 at the time of their dividend reduction announcements.

 

 

We wrote a detailed analysis reviewing how Dividend Safety Scores are calculated, what their real-time track record has been, and how to use them for your portfolio here.

 

Texas Roadhouse has a Dividend Safety Score of 68, indicating a generally safe and dependable dividend. There are three primary reasons for the company’s solid ranking.

 

First, management has been highly disciplined in its overall approach to growth. That means being careful to open stores at a modest but still impressive clip (about 5% to 6% a year increase in store count), while making sure that each one is ideally located and under good management to generate strong comps and earnings growth.

 

This also means that the company maintains a modest earnings payout ratio near 45%, which provides a strong safety buffer for the dividend but also results in lots of excess cash with which to grow the business.

 

 

Another important safety factor is the company’s very strong balance, specifically its low use of debt to run its business.

 

 

For example, Texas Roadhouse is one of the few restaurant companies with a net cash position, which is very rare in a capital intensive industry such as this. In fact, when we compare the company’s relative debt metrics to its peers, we find that Roadhouse’s balance sheet is among the strongest.

 

 

That’s thanks to a leverage ratio (debt/EBITDA) that’s less than 10% of its peers’ and an interest coverage ratio that is very high. In addition, the company’s current ratio (short-term assets/short-term liabilities) is much stronger than average, indicating that Texas Roadhouse’s cash flow easily handles its liabilities and debt service costs with ease.

 

Simply put, Texas Roadhouse’s conservative management team has built the company into an excellent dividend growth stock, and its fortress-like balance sheet and low payout ratios mean its dividend is amongst the most secure in the restaurant industry.

 

Texas Roadhouse’s Dividend Growth

Texas Roadhouse’s dividend growth to date has been spectacular, with its quarterly payout rising 19% annually over the past five years. Management last boosted the dividend by 11% in early 2017.

 

 

However, keep in mind that management will likely have to grow the dividend much more slowly going forward. That’s because the restaurant industry is highly capital intensive, and thus the free cash flow (what ultimately funds the dividend) margins are relatively low as a result.

 

Since Roadhouse prefers to fund its growth internally, rather than with large amounts of debt, this means the company’s payout ratio will likely have to remain around 50% or lower in order to provide sufficient growth capital for long-term expansion. Or to put it another way, in order to maintain a highly safe payout ratio of about 50%, Roadhouse will have to grow the dividend at the same pace as its overall cash flow.

 

And because free cash flow growth is not easy to predict, given the volatile nature of input costs and customer traffic throughout the business cycle, predicting Texas Roadhouse’s long-term dividend growth is challenging.

 

In fact, depending on whether or not management decides to retain more cash flow in the future (by raising the quarterly dividend by $0.02 annually as it has for the past three years), or maintains the current payout ratio and achieves analyst’s bullish long-term cash flow growth of about 15%, Texas Roadhouse’s dividend will likely grow between 7% and 15% a year.

 

While that’s a wide range, it’s fair to say that Texas Roadhouse has thus far proven itself to be a master of good restaurant management and operational excellence and can probably achieve double-digit annual dividend growth over the long-term.

 

Valuation

Over the past year, shares of Texas Roadhouse have performed about in line with the S&P 500 Index. However, that doesn’t necessarily mean its a good time to buy.

 

That’s because TXRH’s forward P/E of 25.7 is much higher than the S&P 500’s 18.5, as well as the stock’s historical norm of 21.9.

 

Meanwhile, TXRH’s dividend yield, at just 1.5%, is less than its five-year average of 1.9% and at a muti-year low.

 

 

With that said, a fast-growing, well-run business like Texas Roadhouse will usually trade at a premium multiple. Even at today’s lofty valuations, the stock be capable of producing long-term total returns of 8.5% to 16.5% (1.5% yield + 7% to 15% annual earnings growth).

 

In other words, Texas Roadhouse still potentially offers double-digit return potential, but with a higher amount of risk than some investors might be looking for given the number of factors that could affect the company’s long-term growth and earnings power.

 

Conclusion

The restaurant industry is notoriously competitive and isn’t usually where one goes to find safe and consistently growing dividends.

 

However, Texas Roadhouse’s founder-led management team has proven itself highly qualified at executing on a disciplined growth plan, one that seems to be working as it carves out an ever larger portion of its market.

 

That makes Texas Roadhouse a potentially attractive long-term dividend growth stock, but one whose high valuation and low yield don’t meet the needs of low risk income investors, such as those looking more for high dividend-paying stocks with defensive qualities.

 

Of course, even if you’re comfortable with Texas Roadhouse’s risk profile, today’s valuation doesn’t look like a bargain, meaning investors may want to wait for a better price before considering adding this quality restaurant stock to their diversified dividend portfolios.