Description

Thesis:

We believe the casual dining sector is ripe with short candidates as many companies lap difficult 2018 comparisons right at a time when labor inflation is intensifying.  In our opinion, TXRH is one of the better risk/rewards within this short theme as the stock has liquidity (many restaurants have tight floats and high short interest), a sky high valuation and material labor inflation risk which will cause significant margin headwinds. We think the market is failing to discount the potential profit shortfall driven by weaker than expected traffic growth and higher than expected costs. We expect the valuation to re-rate closer to a slight market multiple premium of 16x-17x as the company misses profit expectations and the street adjusts growth expectations lower  - implying a share price of low to mid $40s over the next 6-12 months.

Brief Company Description:

TXRH is a casual dining steakhouse chain founded in 1994. It operates almost entirely in the US, where it has 491 company-owned units and 91 franchise units. The brand positions itself as a place where the “working man can get a steak dinner.”

TXRH locations are highly customized: the average box size is 7,500 square feet, the average guest ticket is ~$17, and AUV is $5MM. The restaurants are open only for dinner, with the exception of Saturday and Sunday lunch (and at some locations, Friday lunch).

The Bull Case:

The bull case rests on investors’ view that TXRH is a high quality casual restaurant company with a loyal customer base and an opportunity to continue growing new units. In a challenging casual dining industry (low growth, limited unit growth, saturation), bulls believe TXRH deserves a premium valuation to the market and peers due to its fairly consistent growth. We believe that most bulls believe valuation is reasonable considering TXRH’s low double-digit sales and earnings growth over the past several years.

Short Thesis

1. Labor Cost Inflation

Our conservations with restaurant operators combined with recent economic data suggest that wage pressures show little signs of abating in the near-term and may continue to accelerate.

As you can see from the table 1 and 2 below,  wage inflation is set to continue its acceleration in 2019 driven by moderate economic growth and the ongoing  tightness in the labor market. The company is expecting mid-single-digit labor inflation in 2019. We believe the risks are to the upside based on our conversations with operators and recent economic data.  

Labor costs have been an headwind for TXRH over the past several years, however, the company has been able to offset some of the cost pressures due to a favorable commodity environment for beef prices and better than expected traffic trends. The company increased menu prices 1.7% in November of 2018 to partially offset wages issues, however the continued increase in wage pressure has forced the company to increase price again. On the 4th 2018 earnings conference call, management indicated another price increase of 1.5%. We are skeptical the price increase will allow the company to offset the cost pressures going forward.

Table 1: NFIB Small Business Cost of Labor Single Most Important Problem

Table 2: Nordea U.S Leading Wage Indicator

Table 3: TXRH Cost of Labor as % of Sales

(2) Higher Cost of Goods

Lower than expected beef prices have been a significant tailwind for the company over the past several years as you can see from table below. Lower cost of goods inflation has been a significant driver in helping the company preserve profits despite labor cost issues. Management is guiding to 1%-2% commodity inflation in 2019, but we believe inflationary pressures tilt to the upside going forward.

Beef prices appear to be near cyclical lows. Beef accounts for ~45% of COGS. Historically, peak-to-trough cyclical swings in beef prices have represented ~300bps swings in margin for TXRH, and, thus, the recent low prices are providing a substantial tailwind. Analysts are far offsides modeling 30bps of COGs leverage through 2020 given beef prices are likely heading higher.

Source: OWS, Company Filings

Live Cattle Futures Price:

(3) Traffic Growth Risk

TXRH believes the company has a reasonable amount of pricing power to combat rising inflation costs without seeing much traffic deceleration. However we observe that price elasticity of demand isn't nearly as strong as the company would suggest. When the menu price increases were cut back in 2014, traffic growth surged. When price growth again accelerated in 2015-16, traffic growth again decelerated nearly double the rate.

Valuation: When traffic slowed significantly in the last cycle TXRH relative multiple contracted to a more modest premium vs the greater than 50% premium it supports now.

Conclusion:  

We find THRH to be a compelling short at today’s levels.  A rising labor and food cost environment coupled with an extremely lofty valuation leaves TXRH susceptible to any disappointment in expectations.  We believe fair value is at $40-$45. Using the group average 16x-17x P/E implying 36% downside.

Catalyst

The casual dining sector is ripe with short candidates as many companies lap difficult 2018 comparisons right at a time when labor inflation is intensifying.  In our opinion, TXRH is one of the better risk/rewards within this short theme as the stock has liquidity (many restaurants have tight floats and high short interest), a sky high valuation and material labor inflation risk which will cause significant margin headwinds. We think the market is failing to discount the potential profit shortfall driven by weaker than expected traffic growth and higher than expected costs