Jun 2019: Texas Roadhouse (TXRH)

Midcap Interlude

This month I have decided to take a break from the S&P 500, and instead write about a company in the S&P 400 Midcap Index. Midcaps tend to be smaller and less-established than largecaps, so we are going to evaluate with a lighter touch than usual. Having said that, midcaps probably have a longer runway ahead of them, if they turn out to be great companies. According to this article in Jan 2019, the midcap index has a great 25-year track record when compared to other indices. There are 400 companies in the index, and I found a few worth focusing on. Someday these companies may “graduate” to the S&P 500, as they increase in market capitalization. Next month, I may write about a company in the S&P 600 Smallcap Index, but I haven’t made a final decision about that yet.

Time is a Friend

I really like the company Texas Roadhouse (TXRH). I understand the business model: a casual steak restaurant with an American Western theme. TXRH is currently a member of the S&P 400 Midcap index. The company runs its own restaurants but also has a franchise model to license others to operate a location. Each restaurant has its own butcher onsite. (I have never been to a Texas Roadhouse, so I asked my brother — who lives in Texas — what the restaurant is like. He notes that each customer can hand-select the steak from a display case, and apparently (I found this video) the bread rolls are really delicious especially with the cinnamon butter. He says the steak quality is similar to an Outback Steakhouse, with a fun casual vibe and reasonably priced menu.) I evaluated TXRH as I would evaluate a long-term partnership, looking back at 18 years of historical financial results publicly available. The company only has results going back to 2001, so we won’t be able to look at the usual 30 year histories. TXHR pays out a significant part of earnings as dividends, so we need to talk about dividends. I don’t try to predict TXRH’s stock price, nor do I try to forecast their future financial results. I have no special secret knowledge of TXRH. Everything I like about the company is based on information out in the open. You can verify everything yourself.

If you’re like me, and you’ve never visited a Texas Roadhouse restaurant, you may find it instructive to poke around YouTube. Mostly because of the “narrative fallacy”, i.e our brains are susceptible to being tricked by a really good story, I usually try to stay away from doing too much micro-economic analysis, channel-checks, or otherwise build a story-based-investment-thesis. But based on the videos I saw, there are lots of happy customers at TXRH. People really seem to like eating here (for example, this couple eats there six days a week for the past 15 years … talk about a long-term perspective!). Here is a customer satisfaction poll (based on interviews with 250,000 customers) where TXRH ranked first among full-service restaurants. I wouldn’t necessarily invest in a restaurant because it ranked highly on a customer satisfaction poll … but I think it’s nice to know that customers like the food, especially since I’ve never visited the restaurant.

TXRH is one of the most consistently improving companies currently in the S&P 400 Midcap Index based on the past 18 years of financial performance. The first place I look is at the historical diluted earnings-per-share. Diluted EPS takes into account stock options that can be exercised, and that might dilute the shares outstanding in the future. This potential dilution is why I prefer looking at diluted EPS instead of basic EPS. Some companies issue lots of stock options to executives and employees, and so it’s important to account for that dilution when looking at earnings per share.

Figure 1: Diluted Earnings-Per-Share (EPS)

The company went public in 2004. Since the IPO, the company has been profitable, consistently growing, and performing well through the 2007-2009 recession. In 2008, the diluted earnings-per-share (EPS) was $0.52. Ten years later in 2018, the diluted EPS was $2.20 (a 4.2x increase in 10 years). Many companies struggle during recessions, but TXRH thrived throughout the 2007-2009 recession. These are the types of companies I really like (however I wish I had a longer history to analyze, for example 30 years). Time is clearly a friend to this business.

Time is the friend of the wonderful business, the enemy of the mediocre.

Warren Buffett, Berkshire Hathaway Letter to Shareholders, 1989

Usually during recessions, people eat out less often, but there must be something unique about TXRH that the customers continued to go to this restaurant before-during-after the 2007-2009 recession.

Dividends and Retained Earnings

Last month (May 2019), I wrote about some ways to consider dividend-paying-companies. I won’t re-hash all of that again here. But I was quite surprised to find that TXRH showed such consistent growth while paying out a significant portion of its earnings as dividends. Let’s look at the dividend history below:

Figure 2: Dividends-Per-Share

TXRH started paying a dividend in 2011, of $0.32 per share. In 2018 the company paid a dividend of $1.00 per share. The dividend growth between 2011-2018 represents a compound annual growth rate (CAGR) of 17.7% over 7 years. The dividend payout ratio ranged between 35% and 49%. The dividend payout ratio tells us the percentage of that year’s profits were paid to the shareholders in a cash dividend (45% in 2018). The remaining profits are reinvested back into the company as “retained earnings” (55% in 2018).

Figure 3: Dividend Payout Ratio (dividends-per-share/basic-EPS)

Companies that do not pay a dividend (i.e. dividend payout ratio of 0%) are retaining 100% of earnings in the business. So we can think of a company’s dividend policy as a trade-off between the management team using the profits to grow the business vs. the shareholders taking partial profits out of the business. This is why it’s hard to compare the earnings growth (and thereby the stock price) of a dividend-paying vs. a non-dividend-paying company. The dividend-paying company has less resources to grow the earnings, because the owners are taking profits off the table every year. So it’s all the more impressive when a company has a significant dividend payout ratio, but continues to grow earnings, because earnings growth is coming from a smaller base of retained earnings. The stock price of a dividend payer will go up less because part of the return comes from the dividend itself. I guess this might seem like an obvious point but important to remind ourselves.

Reinvestment Rate vs. Starting Yield

Here is an nice place to raise about the importance of the reinvestment rate. A few years ago Barry Ritholtz at Bloomberg launched a podcast show in 2014 called “Masters in Business”. The very first podcast interview was with Jeff Gundlach, founder of Doubleline Capital. Jeff Gundlach has been called “The New Bond King”, ut at the beginning of his career he was a math PhD dropout playing in a rock band in Los Angeles. Gundlach tells the story of his first job interview (it’s a hilarious story), where he mentions the importance of the reinvestment rate:

I ended up getting one interview … I went in, they said “you have an interesting background, what do you think you would want to do: equities or fixed income?” And I said, “I don’t know what those things are.” And the guy looked at me fairly incredulously and he said, “look, equities: stocks … fixed income: bonds.” I didn’t know what bonds were, but I knew what stocks were, so I said “I want to do stocks”. And the fellow said, “yeah … your background is all this math stuff, we could probably use you in the bonds, so we’re going to put you in the bond thing.”

So I got a book to learn about what bonds were in the week or two before I started working. And it was called Inside the Yield Book by Marty Leibowitz. And there were 2 parts to the book. There was a first half which was mostly text talking about how reinvestment rates were important in calculating out future bond returns … it wasn’t just the starting yield … it was what happened along the life of the portfolio. And then there was a section with all the math behind it.

Jeff Gundlach, Doubleline Capital (Barry Ritholtz “Masters in Business” podcast 2014)

The point is that it’s not enough to look at the starting yield of an investment. The starting yield is an important point, for sure, but the math proves the reinvestment rate is even more important. In the case of stocks, I am referring to the reinvestment rate of the retained earnings (by the management team) … or the reinvestment rate of the dividends (by the shareholder).

The reinvestment rate is the reason I am so obsessed about whether a company shows consistent improvement over the long-term … that’s the best way for me to evaluate whether the management team’s reinvestment rate of the retained earnings will continue to drive the future business value of the company. Every year, the shareholder is entrusting the retained profits of the business back into the hands of the management team.

Warren Buffett talks about this point in his shareholder letters, on the importance of capital allocation:

I would say that the controlled company offers two main advantages. First, when we control a company we get to allocate capital, whereas we are likely to have little or nothing to say about this process with marketable holdings. This point can be important because the heads of many companies are not skilled in capital allocation. Their inadequacy is not surprising. Most bosses rise to the top because they have excelled in an area such as marketing, production, engineering, administration or, sometimes, institutional politics.

Once they become CEOs, they face new responsibilities. They now must make capital allocation decisions, a critical job that they may have never tackled and that is not easily mastered. To stretch the point, it’s as if the final step for a highly-talented musician was not to perform at Carnegie Hall but, instead, to be named Chairman of the Federal Reserve.

The lack of skill that many CEOs have at capital allocation is no small matter: After ten years on the job, a CEO whose company annually retains earnings equal to 10% of net worth will have been responsible for the deployment of more than 60% of all the capital at work in the business.

Warren Buffett, Berkshire Hathaway Letter to Shareholders, 1987

Buffett Ratio (aka “RORE”)

There is a simple calculation that shows the ability of the management team to drive long-term future earnings growth with retained earnings. This calculation shows the cumulative retained earnings over a period of time, and compares that figure to the growth in EPS over the same period of time. In plain language, by retaining the shareholders capital (instead of paying out as a dividend), management team exhibits the ability to increase annual earnings per share. Let’s ignore 2001, because 2002 is the first year of earnings.

  • Cumulative Retained Earnings 2002-to-2018: $10.345
  • Cumulative Basic EPS 2002-to-2018: $15.385
  • Cumulative Dividends per Share 2001-to-2018: $5.04
  • Basic EPS in 2001: $0.235
  • Basic EPS in 2018: $2.21
  • Growth in basic EPS 2001-vs-2018: $1.975
  • Growth in basic EPS as % of cumulative retained earnings: 1.975/10.345 = 19.09%

This simple calculation tells us that in exchange for holding onto $1 of shareholder capital (in the form of retained earnings), the management team was able to increase the long-term annual EPS by 19 cents. This 19.09% illustrates how well the management team is able to grow earnings. Here is an article that describes the background on “Return on Retained Earnings”, but I just call it the “Buffett Ratio”.

Figure 4: Annual Retained Earnings (EPS minus dividends-per-share)

History of Buybacks

The TXRH management team has a sporadic history of buybacks. But despite a few years of heavy buybacks (2008 and 2011), the overall share count doesn’t seem to shrink very much. In fact from 2005-2018, the shares outstanding is fairly steady at around 71M shares. Usually, this means the management’s buyback policy is simply to counteract the stock dilution from stock based compensation. I guess this would be my biggest gripe about the company, I would have wished they were making efforts to actually shrink the share count, especially when the stock is attractively priced (e.g. 2008-2009, 2011-2012). Below is the history of TXRH buybacks starting in 2008.

Figure 5: Annual Stock Buybacks

A simple way to evaluate buybacks is to look at the ratio of annual earnings to annual buybacks. In other words, what percentage of annual profits does the management team allocate towards shrinking the shares outstanding? Below is the ratio of stock buybacks vs. annual earnings.

Figure 6: Annual Stock Buybacks as % of Annual Earnings

Below is the shares outstanding of TXRH. From 2005 to 2018, it has been fairly steady around 71M shares outstanding.

Figure 7: Shares Outstanding (M)

Although not a perfect measure (as the stock price can vary across a broad range through a year), below is a chart of annual price-earnings ratio. This is more useful from a long-term picture, rather than specific valuation ratios available at various times.

Figure 8: Annual Price-Earnings (PE) Ratio

Long-Term Debt as % of Earnings

Many companies finance growth by borrowing long-term debt, so it’s an important final step to verify the future financial stability and resilience of the company by comparing the long-term deb as a % of earnings. Another way of looking at this ratio, is asking how many years of profits would it take to pay off the long-term debt?

Figure 9: Long-Term Debt as Multiple of Annual Earnings

As we see the company historically has a very conservative balance sheet, with negligible long-term debt. Keeping a conservative balance sheet is a good sign if we enter into another recession at any point in the near future. Although I wouldn’t mind the management team adding a little bit of debt to shrink the shares outstanding, especially if it finds attractive valuations on its own stock.

Figure 10: Long-Term Debt including Capital Lease Obligations

Current Ratio (Short-Term Liquidity)

As a final check on liquidity and balance sheet management, it is important to examine the current ratio that divides current assets (assets that can be sold within 1 year) with current liabilities (liabilities that come due within 1 year). This ratio is around 0.9, which means the company has a manageable short-term liquidity situation.

Figure 11: Current Ratio (Current Assets / Current Liabilities)

Interest Rates, Valuation, Yield Curve

When evaluating investments, especially valuations, one of the most important considerations is the current level of interest rates, for example the 10-year treasury bond. The US Treasury Bond is considered a “risk-free” investment, because the US Government can raise funds through many sources such as taxation. So any investment must be evaluated against the choice to collect a risk-free interest rate.

Figure 12: US Treasury Yields as of June 2019
Available at:
https://www.treasury.gov/resource-center/data-chart-center/interest-rates/pages/textview.aspx?data=yiel
d

The 10-year treasury is currently yielding 2.09%, so a good investment opportunity with a “margin of safety” would yield at least twice that level at 4.18% yield. According to Yahoo Finance, TXRH has a PE Ratio (TTM) of 25.91, which taking the reciprocal implies an “earnings yield” of 3.86%. Moreover, Yahoo Finance projects a forward dividend of $1.20 which implies a “dividend yield” of 2.34%. The TXRH earnings yield is not quite twice the 10-year treasury bond yield, but there is still some margin of safety. The TXRH dividend yields more than 10-year treasuries, while also providing earnings growth potential from the retained earnings. I would not characterize this as a great price, but instead a fair price.

Figure 13: Yahoo Finance Quote on TXRH

Here is a quote from Buffett and Munger which illustrate this point … although some people find this philosophy impossible to accept:

I could give you other personal examples of “bargain-purchase” folly but I’m sure you get the picture: It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price. Charlie understood this early; I was a slow learner. But now, when buying companies or common stocks, we look for first-class businesses accompanied by first-class managements.

Warren Buffett, Berkshire Hathaway Letter to Shareholders, 1989

The evolution of Buffett’s investment philosophy is well summarized by Seth Klarman in this video … incidentally I might add another phase of “investing in capital-intensive businesses that benefit from accelerated depreciation, monopolistic utilities with regulated price increases, and opportunities to invest massive amounts of Berkshire cash at attractive returns (all 3 of these points are kind of related)”. The way I think of these investments (e.g. energy power plants, rail cars, railroads, solar power projects) is to imagine a business that has a special exclusive license to invest in high-quality bonds with good yields and favorable tax benefits.

Warren evolved through 3 stages. He went from “buying cigar butts and getting the last few puffs for free” … to buying “great businesses at really cheap prices” … to buying and holding “great businesses at so-so prices” … and maybe even this new area of buying “weird securities from crappy businesses at better-than-market prices” (like BofA preferred). I’m still in phase one.

Seth Klarman, Interview November 2011

If you have been watching interest rates, you may have noticed that they have been going down in 2019 especially since March. The long-end rates (e.g. 30-year and 10-year) has been steadily declining, while the short-end rates (e.g. 3 month) have been steady. As a result, the closely-watched 10Y-3M spread turned slightly negative for a brief period in March 2019, and as of May 2019 it has been very negative. The indicator I am watching is the 30Y-3M spread, which is still positive … when the 30Y-3M spread turns negative, I will start writing about the upcoming recession and ideas for how investors might position their portfolios.

Figure 14: Treasury Yields in 2019

Crisp $100 Bill

Mr. Kent Taylor (Founder, Chairman, and CEO) has a sense of humor. Why else would he insert this into his severance agreement?

Except in the event of a change in control, the 2018 Employment Agreement with Mr. Taylor provides that no severance would be paid to him upon termination of employment, but he would be entitled to receive a gift of a crisp $100 bill if his employment were to be terminated by the Company without cause before the end of the term.

Texas Roadhouse, 2018 Proxy Statement

I don’t know what Mr. Taylor plans to do with the $100 bill (maybe that’s a Texas tradition or something), but I have never seen a “crisp $100 bill” in a proxy statement, or heard of such a crazy employment termination clause.

Concentrated Position

For fun, I like to look at his website (j3sg) that tracks the top 100 holders of TXRH. In particular, I look at the “Portfolio Position” that shows the size of the investment relative to the other positions in the portfolio. I look for institutions that have a portfolio position in TXRH smaller than 5 or 10. Check out j3sg of SIB LLC.

Figure 15: Top Holders of TXRH
Available at:
http://j3sg.com/Reports/Stock-Insider/generate-Institution.php?tickerLookUp=TXRH&pageNumber=1&descending=1&sortBy=value

In the case of SIB LLC, a firm I’ve never heard of, TXRH represents over 10% of the portfolio. I enjoy finding institutions that have this type of investment concentration, because it shows conviction (although I recognize these filings do not represent the full picture, short sales, options, hedges, derivatives, and other investments in other vehicles). Incidentally, I think many of the other names in the portfolio are trucking companies, which I have actually liked for awhile too (previously I invested in the stock of a third-party logistics provider that focused on trucking).

Figure 16: Holdings of SIB, top holder of TXRH
Available at: http://j3sg.com/Reports/Stock-Insider/Generate-Institution-Portfolio.php?institutionid=10486&DV=yes

Conclusion

Texas Roadhouse (TXRH) is one of my favorite companies in the S&P 400 Midcap Index. TXRH is the fourth company I have chosen for a monthly article on this new blog. TXRH has shown consistent growth over the past 18 years, conservative liquidity management, modest use of debt, and a generous and growing dividend for the past 8 years. TXRH’s current valuation is relatively attractive relative to benchmark interest rates, and I believe there is still 1-2 years remaining in the short-term economic cycle. For long-term-focused investors, TXRH is worthy of further study.

Disclosure: I own shares in Texas Roadhouse (TXRH) as of publishing this article (June 2019). I have no intention of selling my position in the near future. This article is not a recommendation. Investors should make their own determination of whether or not to buy or sell this stock based upon their specific investment goals, and in consultation with their financial advisor.