Texas Roadhouse: Waiting For A Pullback

| About: Texas Roadhouse, (TXRH)
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Summary

TXRH has been on fire in the past few years.

Operating results have driven shares up to new highs.

Fundamentals have some catching up to do with the share price and I'd be interested on a pullback into the mid-$20s.

Restaurant chain Texas Roadhouse (NASDAQ:TXRH), the 400+ unit chain that offers a saloon feel with its fresh steaks, ribs and other Texas-sized fair, has seen its stock blast to new all-time highs in the past week. The steakhouse chain has seen a nearly parabolic move since the end of October with shares moving up $5 in just a few weeks. A steady stream of positive earnings reports has kept the buyers coming and shareholders happy. But anything that goes up in a straight line usually doesn't do so for long so in this article, I'll take a look at TXRH to see if there is reason for caution or if the momentum buying is justified.

To do this I'll use a DCF-type model you can read more about here. The model includes inputs such as earnings estimates, which I've borrowed from Yahoo!, dividends, which I've set to grow at six percent annually and a discount rate, which I've set at the 10 year Treasury rate plus a risk premium of 6.5%.

 

2013

2014

2015

2016

2017

2018

2019

Earnings Forecast

             

Prior Year earnings per share

 

$1.08

$1.23

$1.42

$1.59

$1.79

$2.01

x(1+Forecasted earnings growth)

 

13.90%

15.40%

12.26%

12.26%

12.26%

12.26%

=Forecasted earnings per share

 

$1.23

$1.42

$1.59

$1.79

$2.01

$2.25

               

Equity Book Value Forecasts

             

Equity book value at beginning of year

 

$8.58

$9.21

$9.99

$10.91

$11.99

$13.24

Earnings per share

 

$1.23

$1.42

$1.59

$1.79

$2.01

$2.25

-Dividends per share

 

$0.60

$0.64

$0.67

$0.71

$0.76

$0.80

=Equity book value at EOY

$8.58

$9.21

$9.99

$10.91

$11.99

$13.24

$14.69

               

Abnormal earnings

             

Equity book value at begin of year

 

$8.58

$9.21

$9.99

$10.91

$11.99

$13.24

x Equity cost of capital

8.75%

8.75%

8.75%

8.75%

8.75%

8.75%

8.75%

=Normal earnings

 

$0.75

$0.81

$0.87

$0.95

$1.05

$1.16

               

Forecasted EPS

 

$1.23

$1.42

$1.59

$1.79

$2.01

$2.25

-Normal earnings

 

$0.75

$0.81

$0.87

$0.95

$1.05

$1.16

=Abnormal earnings

 

$0.48

$0.61

$0.72

$0.83

$0.96

$1.10

               

Valuation

             

Future abnormal earnings

 

$0.48

$0.61

$0.72

$0.83

$0.96

$1.10

x discount factor(0.0875)

 

0.920

0.846

0.778

0.715

0.657

0.605

=Abnormal earnings disc to present

 

$0.44

$0.52

$0.56

$0.60

$0.63

$0.66

               

Abnormal earnings in year +6

           

$1.10

Assumed long-term growth rate

           

3.00%

Value of terminal year

           

$19.06

               

Estimated share price

             

Sum of discounted AE over horizon

 

$2.75

         

+PV of terminal year AE

 

$11.52

         

=PV of all AE

 

$14.27

         

+Current equity book value

 

$8.58

         

=Estimated current share price

 

$22.85

         

We can see the model has produced a fair value of about $23 for TXRH, a far cry from the $33 shares trade for as I write this. That is an enormous discrepancy so we'll have to dig in to figure out why it exists. But before we do that we need to understand what we're looking at. The model is intended to provide investors with a price at which they can achieve a margin of safety when getting long. A fair value that is roughly 30% the current price not only means there is zero margin of safety but it also implies that the stock is severely overvalued. Does that means TXRH is a short opportunity? Maybe, but we need to look a little harder before making that decision.

TXRH is doing a great job of expanding its business. The company is growing sales at a low to mid-teens rate each year as it expands both its footprint and comp sales. The company's unique brand of saloon-styled restaurants with Texas-sized portions of fresh meat and sides for reasonable value is really resonating with consumers. Top line growth is certainly not an issue here.

As far as margins go, TXRH has held its operating margins steady in the mid-8% range for the last few years. This is a pretty low operating margin that doesn't allow for much in the way interest expense, taxes and other expenses businesses have to pay. Thankfully, TXRH has a nice balance sheet so interest expense is minimal each year but the point stands that when your profit base begins at ~8.5%, it's tough to produce much in the way of net income and it certainly doesn't leave a lot of room for when things get tough; you could see TXRH's profits completely disappear if a rough patch were to befall it.

This leads me to the company's valuation; the stock is currently trading for more than 23 times forward earnings, a premium multiple any way you slice it. While premium multiples aren't necessarily a problem, I think in this case the multiple has gotten a little too premium. Let's take a look.

TXRH is growing sales at 12% to 15% per year and its margins are flat to slightly down. That means that TXRH can't possibly hope to grow earnings more than 12% to 15% per year (all else equal) as the margins it gets to keep from each dollar of sales isn't changing. In other words, unless TXRH figures out a way to increase margins, it has no way of beating analyst estimates of 12% to 15% profit growth for the foreseeable future. And since margins have been very steady for years now, I'm thinking the company hasn't increased margins because it can't, not because it doesn't want to.

Why is this a problem? Because the stock right now is not priced for a company that is growing earnings at 12%; it's priced for a company that is growing earnings at 20% or 25%, a figure that TXRH cannot possibly hope to hit. That's why I think TXRH is overvalued and that's why I'm recommending staying away. We've seen an enormous amount of momentum buying in recent weeks and that's how we got the parabolic spike up to $33. I just don't think that's sustainable and I don't think the valuation is either. There is nothing wrong with this business but, like so many others in today's frothy market, there is simply too much money chasing this stock. I'm afraid that TXRH will experience a tough correction but of course, I don't know when that will be. I am confident it's overvalued but I'm not about to step in front of the momentum buying that has sent shares spiking higher. I just don't think that right now is the right time to get long TXRH; I'd be interested in the mid-$20s or below though. Here's to hoping I get that chance.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.