Texas Roadhouse: 3 Reasons Why I’m Still Reluctant To Buy (NASDAQ:TXRH)

Texas Roadhouse (NASDAQ:TXRH) has been one of the best-performing stocks in the market since its IPO, and for a good reason.

The company has found the formula to provide exceptional value, service, and food while operating at extreme efficiency and growing quite rapidly.

I’ve underappreciated the company for quite some time, and I probably still am, but I’m still reluctant to buy due to three main reasons.

Let’s go over them.

The Embodiment Of The Food Service Sector Investment Appeal

I’ve been covering Texas Roadhouse on Seeking Alpha for over a year now. Unfortunately for me and for those who have listened to my recommendations, I was reluctant to pull the trigger, and maintained a Hold rating through the period, despite immense appreciation of the company’s quality and growth potential.

As reflected by the stock price, Texas Roadhouse has been on a tear over the last decade and really ever since its IPO. The company has been consistently outperforming the S&P 500, as well as the tech-heavy Nasdaq 100, and for a good reason, with 10-year CAGRs of 13% and 16% for revenues and EPS.

Texas Roadhouse, similar to other huge success stories in the category like Chipotle (CMG), has executed the proven strategy of prudent capital allocation while growing its footprint at a rapid pace, combined with a relentless focus on operational efficiency while delivering extraordinary customer satisfaction.

Balancing those out is an art, and requires a top-quality management team, which is what Texas Roadhouse has.

With all that said, and despite my high interest in the sector (I have a large chunk of my portfolio in Chipotle), I never bought, and am still reluctant to buy, as I believe that unlike Chipotle, TXRH’s long-term growth prospects are less clear and simple, specifically when it comes to footprint expansion, throughput, and margins.

Footprint Expansion Opportunity Is Uncertain

As of the end of Q1-24, Texas Roadhouse has 753 locations worldwide, 644 of which are domestic and company-operated, and the other 109 are franchised.

Company-operated domestic locations, which are the primary business of TXRH, have been growing at a 10.4% CAGR between 2004-2023, but since 2009 the average annual growth rate is around 6.5%.

Importantly, management targets 25-30 openings a year, with the majority of them being the Texas Roadhouse brand (for those who don’t know, they also own the Bubba’s 33 brand as well as Jaggers).

To the best of my knowledge, the only full-service restaurant brand with more locations in the U.S. is Olive Garden (DRI), with 917 locations. Other names that come close are LongHorn Steakhouse at 572, and the Cheesecake Factory (CAKE) at 336. There are also franchised FSRs like Applebee’s, which have over 1,500 locations in the U.S., but this seems too much, as evidenced by the consistent decline in the number of locations over the past several years.

At 25-30 openings a year, Texas Roadhouse has over 10 years to go before it reaches the number of Olive Gardens. However, as the company grows in scale, this number will become less and less meaningful to move the needle.

Additionally, I think one of the reasons management chose to enter the QSR field through Jaggers and build another brand in Bubba’s 33, despite having arguably the best restaurant brand in the world in Texas Roadhouse, is that they can see a ceiling in the future. It might be in the very distant future, but it’s still there.

These other concepts are performing well, but it’s still early days, and it remains to be seen whether they can become even half as successful as Texas Roadhouse. I’m especially cautious about Jaggers, which operates in the extremely crowded fast-food burger space.

To conclude this point, footprint expansion is a crucial part of a restaurant’s investment thesis, and we can see more mature names like McDonald’s (MCD) or Darden Restaurants struggling. I don’t think we’re there yet with Texas Roadhouse, but it’s slowly approaching.

It’s Not Quick-Service, There’s A Limit To Throughput

In addition to footprint expansion, the other driver of a restaurant chain’s growth is same-store sales, which encapsulates two factors – traffic, and average check.

The average check in most cases, including TXRH’s, grows due to pricing and consumers’ financial strength. For example, in the current environment, Texas Roadhouse is seeing less alcohol being ordered, and similar items that aren’t crucial to the overall experience.

Texas Roadhouse’s pricing strategy is to offset fixed-cost inflation (i.e. labor and rent), which results in approximately 2%-5% per year.

The most important factor, though, is traffic. Traffic growth shows more people want to come to the restaurant more frequently, and that’s the best indication of the restaurant’s appeal.

One problem for Texas Roadhouse is that people who go to a dine-in restaurant expect to sit there for at least one hour, probably closer to two. As such, the company’s restaurants are limited in the amount of traffic they can endure, as reflected by the long wait lists in many locations. On the one hand, that’s a good thing because it shows they are in demand. On the other hand, the same-store sales growth potential is at least theoretically lower than those of QSRs, which have increasing throughput as a major growth driver.

One metric we can look at to understand this phenomenon is annual revenue per employee. Texas Roadhouse’s number continues to rise, reaching nearly $51,000 in 2023, up ~25% since 2017. That compares to a company like Chipotle, which generated over $85,000 per employee, a 31% increase during the same period.

While a company like Chipotle has all unit growth drivers working full power, Texas Roadhouse is more limited on the front, at least when it comes to throughput potential.

Margin Expansion Story Seems Close To Its Ceiling

In Q1-24, Texas Roadhouse achieved 17.4% restaurant-level margins, a 148 bps improvement from the prior year period. As a percentage of sales, food & beverage declined by 131 bps, labor declined by 51 bps, rent declined by 5 bps, and other operating costs increased by 39 bps.

As we can see, profitability in Q1-24 was the highest since 2018, as all main items continued to normalize. This is a great achievement, but it also brings Texas Roadhouse close to the mid-point of its long-term target for restaurant-level margins in the 17%-18% range.

Regarding overhead, the company achieved an all-time record pretty much across the board, as they continue to demonstrate economies of scale and disciplined cost management. I expect operational leverage on overhead to continue.

With restaurant-level margins close to peak potential and overhead already quite lean, future margin expansion should be somewhat slow. It’s one of those situations where great performance becomes increasingly hard to beat.

All Things Considered, Valuation Is Justified, But Full

I should say, I’ve been dead wrong in the past. I think Texas Roadhouse has a clear recipe to continue to grow revenues at a high-single-digit to low-double-digit pace, with steady yet slow margin expansion. That, combined with buybacks, should result in 12%-15% EPS growth over time, which is much higher than the market.

In previous articles, I thought the company’s multiple already reflected this potential, as it traded in the mid-twenties range. However, as the company continued to beat expectations, and food service became one of the hottest sectors as of late, a multiple expansion was due for this industry leader.

My problem is, Texas Roadhouse is trading at 28 times this year’s projected earnings, and nearly 26 times 2025 earnings. This is the highest multiple it ever traded at, and in my opinion, it’s just too high, and close to the limit.

I think the main reason TXRH’s multiple expanded is because it showed unexpected acceleration across several key metrics, which, as I showed above, I don’t see as sustainable.

I find a 25x multiple on 2025 earnings reasonable, reflecting a small downside from here.

Conclusion

I missed on Texas Roadhouse. I should have projected that its strong leadership team would be able to overcome near-term cost headwinds while maintaining an extraordinary offering that appeals to diners.

I wasn’t the only one who missed, as TXRH has been beating estimates by a wide margin for a long time now. Those beats are the main driver for the multiple expansion, in my view.

Looking ahead, there are several weaknesses I see in the company’s long-term potential compared to other names in the sector, although I still estimate Texas Roadhouse will continue to outperform and outgrow the market.

If your portfolio has no exposure to a fast-growing food service company, I’d consider initiating a position in TXRH despite the valuation. However, if it does, I believe it’s best to stay on the sidelines for now.

Therefore, I rate TXRH a Hold, with a price target of $165 a share.