DOI: 10.25625/gwrvrb
title: Texas Roadhouse Analysis

description: Description I am recommending a short of Texas Roadhouse (“TXRH” or the “Company”). The equity fails to adequately discount medium-term risks that I envision will challenge future results against high market expectations. The Company has already demonstrated some degradation in its business results, having missed street expectations during Q4 2022 and Q1 2023 followed by a low-quality beat during Q2 2023. TXRH is highly regarded for its historical growth but the law of large numbers is a headwind while the historical pattern of earnings growth is also confronting a significant cyclical beef inflation risk in the medium-term coupled with questionable unit growth objectives. While many components of the Company’s COGS witness a moderation of cost pressures, the largest cost component is beef which is confronting double-digit inflation. Although management might have some flexibility to address beef inflation with higher pricing, that strategy could compromise guest traffic as the “value proposition” would be marginalized and guests could seek an alternative, including the biggest competitor (i.e., eating-at-home), or trading-down to fast casual or other proteins within TXRH. Based on some multiple compression (0.5-1.0 to the 2024E EBITDA multiple) coupled with lower EBITDA in 2024 than is currently being forecasted, I envision there is 15-20% downside to TXRH’s equity. The key tenets of my short thesis follow: · Contraction to beef supply is likely a medium-term headwind · Food-Away-From Home prices accelerating above Food-At-Home which historically has influenced less out-of-home meal consumption · Most casual/full-service restaurant companies trade at the middle-to-lower end of historical valuation but TXRH is among the outliers trading at the higher-end · Unit growth objective for core brand is a high expectation · Margin degradation at the unit level · High expectations coupled with its premium valuation is a difficult threshold for TXRH to sustain · Insiders lack much equity alignment and recent insider activity might suggest a lack of insider confidence for significant equity upside in the near-to-medium term · New CFO from outside the restaurant industry might encounter unforeseen challenges and is an inconsistent appointment relative to TXRH’s deep-rooted culture and history of CFOs with restaurant industry experience · Recessionary risk continues to linger During at least the past fifteen years, the “limited service” segment has taken share from the “full service” segment in which TXRH focuses but the Company has effectively grown its units and same store sales through it with a menu focused on hand-cut steaks. Texas Roadhouse is the category leader and well-regarded for its food and service. The Company’s guest traffic growth reinforces its leadership but management is confronting medium-term headwinds that I believe will moderate the Company’s earnings growth. Given its track record of success, TXRH commands a premium valuation but also high expectations to sustain it and I believe the magnitude of the current premium fails to discount likely challenges. The publicly-traded restaurant landscape is littered with “growth” companies that re-rerated much lower as it is very difficult within this highly competitive industry to consistently exceed high expectations coupled with a premium valuation that exceeds 50%. The magnitude of the current premium fails to discount the likelihood of challenges to TXRH’s growth trajectory. When it comes to restaurant “growth” companies, the path of least resistance is higher (until it’s not) as investors who have greatly benefitted from the historical pattern of growth assume the likely trajectory is ongoing growth at a similar pace in spite of what might be one or two quarters of missed expectations. However, if there’s a change to investor sentiment pursuant to being concerned that the growth trajectory is different from the historical pattern, that premium multiple could compress quickly as evidenced from historical re-rating patterns. That said, I am not asserting anything dire with regards to TXRH but I do think a compression of the multiple and therefore the magnitude of the premium is warranted. For my valuation assumption, I estimate the EBITDA multiple will compress to 10.5-11x 2024E which is still a significant premium valuation and roughly in-line with the Company’s pre-COVID median EBITDA multiple. However, I would not be too surprised if the multiple compressed further as catalysts become more visible to challenge the Company’s growth expectation. It’s interesting to note that TXRH recently missed earnings expectations for both Q4 of 2022 and Q1 of 2023. In the former, TXRH’s equity did outperform the SPY by 140bps during the next five days but pursuant to the Q1 miss, TXRH’s equity was down by 7.5% and underperformed the SPY by over 900bps. In regards to the most recently-reported Q2, I anticipated that same-store sales (“SSS”) would be strong and therefore was reluctant to post this idea in advance as I envisioned that the equity would appreciate to a better entry point for sharing the short idea with the VIC community. In fact, although I was wrong with regards to a better entry point for the date of this idea’s posting, the Company did post strong SSS of 9.1%, more than 50bps above consensus, which was driven by 4.7% positive traffic and 4.4% check growth including 5.6% price but this was offset by -1.2% mix. The sell-side is typically focused on SSS metrics as part of their short-term orientation but there is increasing evidence of margin degradation which some sell-side analysts are finally calling attention towards and I believe the challenge to margin is more than a short-term issue. After two consecutive EPS misses of -13.6% (Q422) and -5.9% (Q123), TXRH beat the EPS expectation but only by 1.7%. The quality of the “beat” was weak though since TXRH’s restaurant-level margin, at 15.7%, was 40bps worse than expected; the upside was driven by G&A lower than expected plus a lower tax rate. The lower restaurant-level margin is explained by higher labor inflation and some negative check mix and both of these issues are likely to linger. Management acknowledged labor inflation issues by raising their previous labor inflation forecast from 5-6% to 6-7%. To provide “legendary service” requires a high labor ratio and “it’s hard work to make those sides from scratch every day.” Management noted that although historically they target labor hour growth at 50-55% of traffic growth, they have recently deviated from that pattern in an effort to “purposely to give our managers a little quality of life.” Although I admire senior management’s focus on their GM’s quality of life which reinforces the deep-rooted culture at Texas Roadhouse, it comes at a cost and if such persists, then earnings growth would moderate as should the premium valuation multiple in a “normal” environment. Management has remained steadfast regarding not being inclined to price its menu to offset inflation that materializes from commodities. Their pricing strategy is mostly focused on what management deems “structural labor inflation.” The CEO said during an interview last year, “I’ll tell you the goal isn’t necessarily to offset inflation. We want to make sure that we’re really thinking of that value proposition as we usually do. So that’s going to be more of the focus for us than trying to increase our margins on a short-term basis.” A core component of my short thesis pertains to higher beef prices. If management were to raise prices to offset beef inflation, the Company is likely to witness some degradation of check mix and/or guest traffic counts from trade-down dynamics that erodes comparable sales. The market would likely be disappointed given the premium valuation discounts the “steady hand of both traffic and check mix” growth that TXRH has long delivered. On the other hand, the absence of pricing to address beef inflation will lead to margin degradation that also could disappoint the market. Furthermore, there is a strong case of worsening macro considerations confronting consumers that is likely to linger in the near-term as a trade-down issue that challenges check mix even if traffic remains favorable. When I asked a Texas Roadhouse Managing Partner what he thought about menu prices being raised to offset escalating beef prices, he said, “That wouldn’t be a particularly good idea for our chain which is known for its value conscious customers.” Although consumer demand remains strong for dining at Texas Roadhouse, the negative check mix at 120bps (specifically less alcohol and more “value”) after 80bps of negative mix in Q1 might be evidence of some looming consumer weakness. Management noted there has been a moderation in alcohol attachment for a couple of quarters. The investment community is enamored with TXRH’s guest traffic growth and whether the deterioration in check mix is a leading indicator for lower guest traffic remains to be seen. The CEO explained the negative alcohol mix recently when he said, “…you have what I would call that consumer who was happy to be back out there who had some extra money in their pocket, whether that has been from stimulus or just not having other places to spend it. And they were maybe getting a drink that they were not historically getting or getting a second drink. And now, you’re maybe seeing a little bit more of a return to normalcy…” I do not think guest traffic is likely to decline in the near-term but since I do subscribe to an eventual softer economic environment driven by the degradation to consumer spending, I believe that guest traffic, check mix, and therefore SSS will erode accordingly. For the time-being though, Texas Roadhouse has been a beneficiary from both trade-up and trade-down dynamics. The strong SSS performance from Q2 was reinforced for the current quarter-to-date at 10.7%. However, the Q3 compare gets tougher in August and September at ~10% versus the ~4% comp in July. The Company’s pricing strategy has long been to underprice inflation to avoid compromising the value proposition. TXRH’s average check is $21 which is ~20% below its core competition. It is a delicate balance to protect margin in an inflationary environment without turning off too many guests. Management has remained steadfast to view wage inflation as structural but not to “over-react” to commodity price inflation. Management believes full-year commodity inflation will be at the higher-end of its 5-6% outlook this year. Starting next year, I expect this could become a more significant headwind than currently anticipated based on the significant tightening of the beef cycle as described in more detail below. As noted by management, “[Beef] has the potential to be a pressure point again next year, it’s too soon to know what that means.” This is not likely a significant issue for 2023 since ~75% of the overall basket is locked for Q3 and ~35% for Q4 but challenges are likely to escalate at least in 2024 and 2025. A significant risk to TXRH is the likelihood that beef prices will be higher in the medium-term. Approximately half of the Company’s COGS is beef and the favorable pricing that has accrued to TXRH’s benefit in recent years is reversing. During the recent earnings call, in response to a question pertaining to beef being higher for longer and what would be the contingency plan, the CEO said, “…we don’t know what’s going to happen in beef…There is a lot of chatter out there…It’s a big part of our menu. It is the cost of doing business right now. We do need to be very cautious and careful on the pricing to make sure that we are continuing to drive our value component…And I think in the long run, we will still win with that strategy.” It remains to be seen to what extent beef inflation rises in the coming years but the beef cycle is longer than other proteins and since hand-cut steaks are the main attraction for guests at Texas Roadhouse, I believe that beef inflation will loom as a considerable risk to earnings growth in the medium term. Management will confront a tough choice to price its menu to preserve margin (which is already declining) but by doing that, the Company (by its own admission) risks marginalizing its value proposition and thereby its guest traffic. On the other hand, leaning towards the value proposition for its guest is consistent with the Company’s longer-term strategy but margin would likely suffer accordingly. The investment community might choose to focus on the guest traffic as the positive even if such a decision would likely come at the expense of medium-term earnings growth. Undoubtedly this is a risk to being short TXRH but I believe that the recent earnings misses evidenced during Q422 and Q123 coupled with the low-quality earnings beat in Q223 is evidence of cracks in the growth armor at TXRH. To maintain the magnitude of its premium valuation, the market expects TXRH to consistently beat the estimates. Although I know these “growth” companies frequently get a pass, I think the magnitude of the premium valuation will warrant some multiple compression. On a system-wide sales basis, Texas Roadhouse generated the twenty-third largest amount of sales in the U.S. during 2022. The Company and its franchisees operate over 700 restaurants system-wide. The substantial majority of units are Company-owned, Texas Roadhouse-branded restaurants that focus on serving steak in the casual dining segment. Although less than 10% of domestic units were franchised, all 41 international units were franchised. The Company’s other brands are Bubba’s 33 and Jaggers. The Texas Roadhouse branded concept has 566 domestic units that are owned and operated plus 54 domestic franchised units. Approximately 20% of TXRH-owned units are in Texas and Florida. Management recently increased its target for U.S. units from 700-800 to 900 and therefore a key bullish thesis is the prospect for unit growth at management’s mid-teen IRR target. Texas Roadhouse is a full-service, casual dining restaurant concept focused on hand-cut steaks in addition to ribs, seafood, chicken, pork chops, burgers, salads, and sandwiches. Alcohol mix in 2022 was 11% for the Company overall. On a sales basis, Texas Roadhouse is ~40-50% larger than its core competitors Outback Steakhouse (owned by Bloomin’ Brands) and Longhorn Steakhouse (owned by Darden). In the decade that preceded COVID-19, the Company’s comparable sales averaged 4.5% comprised of guest traffic count at 2.8% and per person check at 1.7%. Same store sales was positive in every year. The market ascribes a premium valuation to TXRH for its same store sales consistency and especially the guest traffic count growth. As the Texas Roadhouse brand approaches its saturation point, there is indeed wisdom from TXRH’s management to invest in newer restaurant themes that inherently take longer to plateau but both the “law of large numbers” coupled with the challenge for any new concept to achieve similar success as the legacy brand is most likely to linger as an ongoing headwind relative to high expectations compounded by a premium valuation. In addition to the unlikely success of emerging concepts, it is expensive for successful concepts to ramp to a requisite scale and therefore can be dilutive to overall ROIC which could also compromise a premium valuation. For example, this proved to be the case for TXRH’s main peer Outback Steakhouse. The Company introduced the Bubba’s 33 sports bar concept in 2013; there are currently 45 such units. The Company introduced Jaggers as a fast casual concept in 2014; at the end of Q1, there were just seven such units. The short thesis is focused on the namesake brand as neither of these two concepts will significantly influence the Company’s results. On a unit level basis, restaurant margin for Texas Roadhouse was 16.0% in 2022 while Bubba’s 33 was 12.7%. Both the Bubba’s and Jaggers concepts were introduced around a decade ago when management harbored some concern about the sustainability of unit growth for its namesake brand and therefore sought to introduce new concepts to supplement the Company’s growth but neither of those concepts has been successful yet. From primary research, I’ve learned that the magnitude of unit growth of the Texas Roadhouse brand has exceeded management expectations but whether that can be sustained relative to market expectations is among the short thesis considerations. Further details regarding the short thesis follow below: Contraction to beef supply is likely a medium-term headwind · Cattle futures recently climbed to their highest prices on record · Farm-level cattle prices and wholesale beef prices were 26% and 15% higher as of June 2023 from the prior year · Overall beef cattle inventories are in the early innings of contraction, thereby resulting in a meaningful deceleration to beef production o Drought, forage availability, and high input costs have led producers to liquidate their herds over the last few years, shrinking the national herd size o Drought is a significant contributor to the recent decline in beef cow inventory because of the detrimental effects of dry weather patterns on pasture and range conditions; at the beginning of 2023, nearly 93% of U.S. beef cows were in states where most of the pasture and range were rated in “very poor to fair” condition o Decline to replacement inventory provides evidence of supply contraction over at least the medium term since the beef supply tends to grow and shrink in cyclical patterns that are roughly 8 to 12 years o The last cattle cycle, which began in 2014, is now in a contraction phase, with inventory contracting at an increasing rate each year since 2020 o At the beginning of 2023, the supply of bred heifers was down over 5% to the lowest inventory since 2011; the July beef cow herd was down over 9% from its 2018 peak and more than 1% below the 2014 trough o According to the Farm Journal, the July 2023 beef cow herd is the lowest in the entire data series dating back to 1973 o As noted by South Dakota State University’s field specialist in livestock business management, “It’s hard to escape the Economics 101 supply and demand model. When all segments of the beef industry are examined, there is a decline in the number of cows in the herd, all the way to the number of animals on feed and being processed each week. A reduced number of animals results in fewer pounds of beef available to cover the various marketplace demands.” · During the last contraction period (2007-2014), beef supply contracted by ~10% and boxed beef prices increased by over 75% from trough to peak o Largely resulting from inflationary beef prices, TXRH’s COGS increased by 270 bps from the trough of 32.6% in 2010 to 35.3% in 2014 (and then increased another 60 bps in 2015 to 35.9% based on locked-in pricing) o The expansionary period was a significant contributor to the lower COGS that troughed at 32.3% in 2019, this was notably 360 bps better than 2015 o However, largely driven by non-beef inflationary components, during 2022, when commodity inflation was 10.8%, TXRH reported its food and beverage costs had increased to 34.6% o During the “contraction period”, the average and median COGS was ~34.3%; during the recent “expansion period”, the average and median COGS was 33.6% and 33.2%, respectively o TXRH will confront escalating beef prices in the medium term; management has remained steadfast with a pricing strategy that is not likely to offset those inflationary headwinds as the Company’s strategy ascribes more emphasis to the guest value proposition versus a preservation of margin o It remains to be seen if TXRH’s guest count and check mix can expand at a sustained rate to eclipse the headwinds from beef inflation o I assert that beef inflation challenges will loom for the medium-term and the beef pricing headwind coupled with potential consumer weakness across TXRH’s core demographic is not adequately discounted by TXRH’s premium valuation · Approximately 50% of TXRH’s food and beverage costs relates to beef o The 2022 tailwind from beef prices has reversed and is likely a medium-term headwind although in the near-term the issue will likely be contained given locked-in pricing § During the Q1 earnings call, management’s response to the question on beef and related potential pricing relief: “…we’re not going to get into the specifics of what percent of our beef is locked or is not locked. But it’s fair to assume with half of our basket being beef that our overall commodity lock has to be somewhat in-line with what our beef is…it will drive the majority of our inflation for 2023…On the last point you brought up about menu pricing, that is still the way we think about it, we price for the structural component of inflation, which tends to be wage inflation. And we don’t tend to overreact in price for the cyclical items like commodities and beef which will probably be inflationary for a period of time.” § During the Q2 earnings call, we learned that ~75% of the overall basket is locked for Q3 and ~35% for Q4; management also noted full year commodity inflation would likely be on the higher end of their full-year range of guidance of 5-6% which is primarily related to beef inflation o With even fewer cattle expected to be marketed in 2024, beef supplies are projected to remain tight; the USDA recently raised its 2024 projected fed steer price by $3 per hundred weight in anticipation for what the USDA estimates to be a 12% increase over 2023 o From a variety of primary research sources, a more pronounced cattle inventory contraction, and management’s stated pricing strategy, it is likely that TXRH will experience increased beef prices during the next couple of years and COGS of “at least 35% which is higher than what is generally expected” o As sourced from a highly-regarded, long-tenured steakhouse restaurant primary research contact, “It is possible, and in fact probable, that customers trade-down to lower-priced steak menu items or lower-priced proteins which could alter the COGS favorably but that might fly in the face of the comparable sales data that Wall Street is so enamored of with this company.” Food-Away-From Home (“FAFH”) prices accelerating above Food-At-Home (“FAH”) which historically has influenced less out-of-home meal consumption · Between the 1970s and early 2000s, FAH and FAFH increased at similar rates but from 2009-2019, their growth rates diverged; while FAH prices deflated in 2016 and 2017, monthly FAFH prices rose consistently · In 2020, both FAH and FAFH prices increased at roughly 2.5% but during 2021 FAFH prices increased at a rate 100bps higher than the 3.5% increase for FAH prices and then in 2022 reversed as FAH prices increased at a faster rate at 11.4% versus FAFH at 7.7% · From March 2022 through January 2023, FAH inflation was at least 300bps above FAFH inflation (and peaked at ~550bps in July/August 2022); this empowered many restaurants to raise prices relatively aggressively · While year-over-year price increases have slowed for most food, the differential of FAFH was 300bps higher as of June at 7.7% versus 4.7% for FAH and the expectation is that FAFH will continue to index higher than FAH in the near-term o In 2023, USDA’s Economic Research Service expects FAH prices will increase by 4.9% versus FAFH increasing at 7.5% o The USDA’s current forecast for 2024 is that the differential of FAFH will accelerate to 520bps as FAFH prices will increase by 6.1% versus FAH prices at 0.9% · The YOLO dynamic that has been a recent catalyst for increased services, which would include dining out, could be eclipsed by the ongoing higher FAFH pricing differential; and that differential is likely to remain structurally higher in the near-term based on tighter labor conditions within the hospitality arena · In general, grocers respond to increasing food prices by raising prices but they respond to decreasing costs by reducing prices · Restaurants do not typically lower prices as a structurally-driven strategy; however, while competing with lower FAH pricing, it is typical to witness an increased magnitude of promotional strategies to drive restaurant share o Historically, TXRH’s management avoided promotional strategies but that is not the case for TXRH’s competition o To the question from the sell-side during the Q1 call, “A couple of your peers have gotten a little bit more aggressive with promotions…Have you seen continued irrational behavior as relates to promotions? o Management responded, “Yes…obviously, they’re being pretty aggressive out there.” o TXRH’s strategic positioning has generally been more “value” relative to both Outback and Longhorn as evidenced by their top-selling menu item, specifically the six-ounce sirloin, priced at $13.99 which is 11.5-14% below its core competitors o Although BLMN’s management recently communicated less discounting on its Q2 call, they are committed to increased advertising which is also a strategy embraced by Darden which owns Longhorn Most casual/full-service restaurant companies trade at the middle-to-lower end of historical valuation but TXRH is among the outliers trading at the higher-end at ~14x 2023E EBITDA which is a ~55% premium to the peer group · Given a level of consistency in comparable sales and guest traffic generated by the Company, TXRH has frequently traded at a premium valuation and some premium is deserved but the magnitude of such has grown while expectations for TXRH have risen · On a 2023E and 2024 P/E basis, TXRH’s premium is ~50% on a median basis and ~20% on an average basis · On a 2023E and 2024E EBITDA multiple basis, TXRH’s premium to the peer group is ~55-60% on a median basis and ~50-55% on an average basis · Higher multiples are undoubtedly expected for stronger growth; however, on an earnings basis, the forecast for TXRH’s earnings growth is roughly in-line with the peer group · On an EBITDA basis, the estimate for growth at TXRH in 2024 is faster than all peers other than RRGB, BRJI, and CAKE; TXRH’s 2024E EBITDA multiple is 100% more than the average of those three peers · TXRH’s closest peers focusing on steak within the casual dining segment are Outback Steakhouse and Longhorn Steakhouse owned by BLMN and DRI, respectively o On a 2023E basis, relative to BLMN, TXRH’s premium P/E and EBITDA multiple is over 150%; the magnitude of the discounted valuation at BLMN is presumably among the reasons that Starboard recently announced their ~10% stake in BLMN o On a 2023E basis, relative to DRI, TXRH’s premium P/E is ~30 o On a trailing twelve-month basis, the 16% ROIC exceeds that of BLMN, at 13%, and DRI, at 15%, but I do not believe the magnitude of differential justifies the magnitude of TXRH’s premium valuation o The Texas Roadhouse brand is over 95% of TXRH’s operating income which exceeds the more diversified mix for both BLMN (Outback is ~50% of sales) and DRI (Longhorn is ~25% of sales and 20% of operating income) o The premium valuation at TXRH is undoubtedly related to its better performance versus its closest peers; during 2022, TXRH’s guest traffic count increased by 1.9% while Outback suffered a 6.3% decline § However, as one primary research source said, “This type of disparity in performance is not often sustained historically as promotional strategies and changes for improvement cause some share to shift back.” Unit growth objective for core brand is a high expectation · During 2022, the Company’s sales surpassed $4B and that’s a double from five years ago; with the recent momentum and perhaps some hubris, the CEO recently called for a doubling of revenue again over the next decade. We can view the company capital structure here: Cost of equity calculator Cost of debt calculator WACC calculator · Management recently raised its goal for the Texas Roadhouse brand to grow from 700-800 units to as many as 900 units with a modified location strategy that historically focused on medium-sized cities to include smaller markets with populations of 40,000-60,000 · Management raised its unit growth goal despite increasing evidence of higher capital investment per unit which increased by over 25% from 2019-2022 to $6.9M for Texas Roadhouse and by over 15% from 2019-2022 to $7.8M for Bubba’s 33 · The Company recently raised its 2023 estimated capital spending to $300M (from $265M0 to include higher than expected buildout for new units despite the earlier forecast that capital spend per Texas Roadhouse would be flat and decline for Bubba’s 33 · Although management recently reiterated their ongoing confidence for achieving a mid-teen IRR for its new unit growth, the increasing capital build obviously raises the bar for the requisite through-put while management’s strategic intent to buildout smaller markets is likely to result in lower sales and profitability per unit relative to the historical returns generated from the Company’s legacy focus on medium-sized cities · The magnitude of “white space” growth available for the core brand was recently raised because the Company’s strategy to drive growth through diversification with Bubba’s 33 and Jagger’s has not proven to be as effectively successful relative to management’s initial expectations · I believe TXRH’s premium valuation discounts a level of new unit growth and incremental returns that might disappoint the market relative to high expectations and one can discern some increased scrutiny developing from the sell-side pertaining to new units o During the most recent earnings call, management responded to a question regarding management’s confidence in Bubba’s new unit openings, “…we feel very good about our opportunity to get some Bubba’s open this year…probably see five…and in the next couple of years, want to be in that five to seven Bubba’s opening with a maybe next goal after that getting closer to ten openings. Again, the slowdown in our number of openings for this year has nothing to do from anything on our side of our excitement for any of our concepts. It is more of an issue of things that are out of our control, getting permanent power to a restaurant site and the timing of work getting done…And our overall trends in the different concepts are also very strong…And certainly, Bubba’s with less of a focus on steaks is not feeling the level of inflation that a Roadhouse it…” · If there was much “white space” unit growth potential for the Texas Roadhouse brand, then management would not have recently modified their location strategy towards targeting smaller markets; it remains to be seen whether this strategy will generate attractive returns relative to high expectations but the historical context for steak-focused casual dining to drive units much more than what TXRH has admirably achieved is not good; as noted below, it’s probable that management feels they must experiment some to continue meeting increasingly higher expectations to sustain their premium valuation · During February, the interim CFO said, “We do have a restaurant in New York City and New Rochelle…and have had some success in lower-populated, smaller areas…For a company our size and what we want to accomplish, we have to try some new things. We have opened the scope of what we will try so we can expand and have success and that may look a little different than what we’ve done in the past.” Margin degradation at the unit level · While TXRH’s management targets 17-18% margin at the unit level, there has been some recent margin degradation at the Company which I believe is just beginning o Since 2017, restaurant-level margin has declined each year (this excludes 2020 from the analysis), from 18.4% in 2017 down to 15.7% in 2022 o Management explains this being primarily driven by higher labor costs from both wages and staffing initiatives o There’s also the dilutive impact from the other concepts--Bubba’s 33 and Jaggers--although Bubba’s was not disaggregated until recently (during 2022, the Texas Roadhouse brand generated 16.0% at the unit level, down from 16.9% in 2021, but Bubba’s 33 was only 12.7%, down from 16.6% in 2021) o On a YTD basis, margin declined by 80 bps at the Texas Roadhouse brand to 15.9%; Bubba’s increased by 20 bps to 14.7% · Assuming beef inflation becomes the medium-term headwind as I envision and management remains steadfast to its pricing strategy being influenced by “structural” wage inflation and not menu-driven inputs, this could generate ongoing margin pressure absent trade-down dynamics by guests to menu items at a higher margin but this would concurrently pressure the comparable sales metrics as per person checks would suffer accordingly · Management does not articulate a confident path towards their margin objective o In response to a question on the most recent earnings call pertaining to the 17-18% long-term target and whether it’s just a matter of the commodity cycle or some strategy or other initiatives, the CEO said, “…the commodity cycle is going to continue to be our challenge…and as we adjust to the labor and to the commodity knowing that or expecting one day that the beef will start to slow down a little bit and give us a chance to catch up…We’re just waiting for a few things to turn our way to help us there.” o It’s easy for management to raise their unit growth objectives and maintain their restaurant margin objectives for bullish analysts to feed those metrics into their models but there is already evidence of some degradation in earnings growth and quality and I believe the headwinds are escalating relative to the high expectations that are discounted by the valuation and by management also having kept those expectations high · In addition to labor and commodity-related cost pressures challenging the unit-level margin, TXRH is confronting escalating utility costs as well as repair/maintenance expenses High expectations coupled with its premium valuation is a difficult threshold for TXRH to sustain · The growth trajectory that market participants have come to anticipate and are discounting in TXRH’s premium valuation will become more challenging to sustain · The success of Texas Roadhouse is undeniable; it’s a proven value proposition for its guests that has been effectively executed by a breadth and depth of “Roadies” (the term used to describe the Company’s passionate employee base) · However, the law of large numbers is driven from the Company’s track record of success o The “law of large numbers” is a headwind since it is very challenging to grow a casual dining brand, and especially one focused on steak, much further in units · Other than the QSR segment that derives a higher valuation from a primary focus on franchising, there are few publicly-traded companies in the restaurant sector, particularly within the casual dining segment, that have sustained a valuation multiple like that ascribed to TXRH · The restaurant business is among the most challenging but even more so within the public markets which chases growth with much roadkill across chains that failed to sustain a pattern of exceeding high expectations · The short thesis is not premised on the demise of TXRH but for context it’s worth recalling some strong steak-focused, casual dining venues from the past that ultimately failed relative to previous high expectations; o Ponderosa/Bonanza Steakhouse had ~700 units at its peak in 1989, the parent company filed for bankruptcy in 2008 and emerged in 2009; there were roughly 20 units at the end of 2022 o By 1986, Western Sizzlin had 600 units and was sold in 1988 in a $95M LBO; the new owners had a five-year plan to grow the chain to 1,000 units but filed for bankruptcy in 1992; today there are less than 50 units o Ryan’s Steak House grew to nearly 300 locations and had been recognized as one of the best small companies in America and was named best steak house in the U.S. in 1990 but by the mid-1990’s the management team sought diversification given intensified competition; the parent company of Ryan’s Steakhouse filed for bankruptcy in 2012 o Steak and Ale had nearly 300 locations at its peak but filed for bankruptcy in 2008; there is a current attempt to relaunch the brand o Sizzler which also filed for bankruptcy had more than 270 locations at its peak, now less than 100 o Logan’s Roadhouse had nearly 250 units at its peak after being called “one of the hottest concepts” in the restaurant industry; they operated under numerous different owners including as a public company that more than doubled within two years of their 1995 IPO but under PE fund Kelso’s ownership filed for bankruptcy in 2016 and then again in 2020 from COVID, now controlled by Fortress, Logan’s has less than 50 locations · The point from the aforementioned is more than nostalgia and it is not meant to suggest that TXRH will suffer a similar fate but there are few restaurant concepts that have sustained their leadership position, and especially in the casual dining steak segment o From one primary research source, “The challenge to execute so effectively for so long as expectations from guests rise and also change is very hard to maintain. These type of concepts are also structurally hard to change when competition comes with a better mouse trap and someone has always been ready to introduce a better concept. Share shifts happen more often across the steak segment than other foods. Outback is a good example of having been the grand-daddy until that leadership position was assumed by Texas Roadhouse.” · TXRH’s closest peer is Outback Steakhouse; for many years, investors and analysts monitored the parking lots and waiting times across Outback’s locations as their business model enamored so many until the chain struggled as historical patterns have suggested for many other well-regarded chains o Outback was founded in 1987 and went public (referred to as “OSI”) in 1991; the founders sought to target a market segment above well-regarded Ponderosa and below Ruth’s with their collective experiences from Steak & Ale, Bennigan’s, and Chili’s o At the end of the 1990s there were ~575 domestic units and management forecasted a ceiling of 700-750 o During 2005, one of Outback’s founders noted how Wall Street would punish the company had it not grown its overall units by 120 o At the end of 2006, there were 786 units o Although management had already sought to diversify (ala TXRH with Bubba’s 33 and Jaggers) its business mix with a variety of emerging concepts like Carrabba’s, Bonefish, Fleming’s, and Cheeseburger in Paradise, Outback was by far the key driver of overall profitability and the “law of large numbers” served as a headwind to the potential contribution from its other concepts o Like TXRH, Outback’s deep-rooted culture, quality food and service was highly- regarded by the equity market and accorded a premium valuation; however, the trajectory of growth and returns proved too difficult to sustain o During 1999, OSI generated $228M of EBIT and in 2005, OSI’s EBIT was $227M despite the $1.2B of growth capital incurred from 1999-2005 o For more than a year, Outback reported negative sales and traffic trends o Bain Capital and L Catteron announced a take-private during 2006 and OSI founder Chris Sullivan was quoted as saying, “If you look back to the mid-1990s, Brinker International and Darden Restaurants were kind of at the point where our concepts are at right now. We are getting ready, getting positioned, for the next 15 to 20 years…and that’s when your stock gets hammered.” o Trends at Texas Roadhouse remain strong but historical patterns suggest “its best days might soon be behind them” Insiders lack much equity alignment and recent insider activity might suggest a lack of insider confidence for significant equity upside in the near-to-medium term · Directors and all executive officers as a group own just 0.5% of TXRH · During the past year, insiders have sold over $8.5M of stock; during the past four years, insiders sold ~$75M at ~$75 (on average) · TXRH’s CEO recently sold via his 10b-1 plan at a targeted $115 price trigger which was in addition to his price trigger selling at $90 and $95 last August New CFO from outside the restaurant industry might encounter unforeseen challenges and is an inconsistent appointment relative to TXRH’s deep-rooted culture and history of CFOs with restaurant industry experience · New CFO Chris Monroe started in June after almost 32 years with Southwest Airlines across a variety of capacities including Treasurer for over 17 years · Prior CFO retired less than five years after her appointment although she had worked within TXRH’s finance department for almost 20 years before becoming CFO · Based on surveys of the best stock research websites, a review of TXRH’s prior CFO talent demonstrates promotions from TXRH’s finance department except the CFO (who later became TXRH’s President) who was CFO during the 2004 IPO pursuant to his 15 years of financial leadership within the restaurant industry · Given the Company’s emphasis on its culture, I do wonder if the “outsider” CFO will be effective with his long-tenured colleagues and how relevant his numerous years of low-cost airline experience will be to TXRH · It’s not certain why the Board was unable to attract someone with industry experience but my dialogue with selected search professionals suggest it might have something to do with the perception of the Company’s HQ location coupled with a perception of limited equity upside and a tougher “slope” of financial results in the near term relative to other alternatives Recessionary risk continues to linger · For over a year, many investors, business people, forecasters, commentators, and economists have predicted that the U.S. economy was about to head into a recession o The most-anticipated recession has been pushed out repeatedly o The calls for a potential recession are relatively well-documented and undoubtedly the “wall of worry” expectation of a recession which has yet to occur is likely among the reasons the equity market has appreciated this year o A majority of the hitherto bearish equity strategists have capitulated and soft-landing (and “no landing”) expectations have risen · In the absence of a broader or consumer-driven recession, there is increasing pressure on the consumer as evidenced by escalating credit card debt and the resumption of student loan payments this Fall (some experts believe this could be a 100-200 bp headwind to discretionary spending) while pandemic savings are eroding across those within the lower and middle income population o I won’t argue about the likelihood of a recession but I do think it’s worth noting: § When the Great Recession tightened wallets, casual dining was among the hardest hit sectors and Texas Roadhouse was not spared § Although the Company’s same store sales were down less than the casual dining segment at negative 2.3% and 2.8% in 2008 and 2009, respectively, after being up 1.4% in 2007, TXRH’s equity declined by over 70% from its peak during February 2007 until finally bottoming during November 2008 § Undoubtedly if macro issues were to worsen across the discretionary consumer sector, TXRH will suffer accordingly Selected Risk Considerations · Although beef inflation is a core premise of the short thesis, the best stock screeners forecast that the lower levels of inflation and in some cases deflation of other commodities could provide an adequate buffer to preserve margin if there’s a trade-down dynamic from steak; however, in that scenario, comps would likely suffer with a lower average check and moderation of comp growth is frequently a catalyst for multiple compression · Pre-COVID, TXRH’s guest traffic and comparable sales (note: defined by the Company to include those units opened for a full 18 months) was consistently higher each year, at 2.8% and 4.5%, respectively, for the prior decade (on an averaged basis); the risk to the short thesis is the Company’s ability to sustain this trend, particularly guest traffic, and especially with any operating leverage at the unit level which has been lacking of late · Wage inflation and labor shortages have been a challenge for TXRH but the magnitude of both recent headwinds is moderating; management has called out labor as a main challenge to its deteriorating restaurant-level margins but the flip side is that wage inflation is the main factor that drives TXRH’s pricing strategy so while an improving labor situation can enhance the labor expense factor, it might also marginalize menu pricing as a counter effect · TXRH has a very strong balance sheet (currently net cash) and although insiders are selling their stock, there is a Company buyback of ~$135M remaining pursuant to a repurchase of 0.5% of outstanding stock YTD at ~$108 · A market structure dominated by momentum-based strategies and strong inflows has buoyed stocks to historically high valuation multiples, at least based on a historical context versus rates. The direction of both the market and specific stocks has primarily been about the fund flows that fuel passive investing (or better characterized as “allocations”) indiscriminately. With over 25% of TXRH ownership being passive as evidenced by the shareholder ownership that BlackRock/Vanguard/State Street comprise in aggregate, TXRH might be in a favorable position of passive-driven allocations. If it’s all about the fund flows as well as “growth at any price,” that is favorable to TXRH as a perceived “restaurant-category growth company,” at least for the time-being. · In a “normal” world, I think there is limited room for multiple expansion, there is of course risk to any short that the equity will appreciate but I have yet to size TXRH to a fully-sized position which I intend to do in response to potential further price appreciation unless I deem the price action to be validation against my short thesis.