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Why Slow Growth May Be In Store For This Restaurant Chain

Friday - 8/23/2013, 7:57am  ET

When a company starts paying a dividend, investors often view the announcement as good news. But a dividend represents money that is not reinvested back into the business, and it's an admission by management that growth opportunities may be drying up. A fast-growing company should be shoveling all of its earnings back into the business, not paying off investors.

This leads me to steakhouse operator Texas Roadhouse . The stock currently trades for around $25 per share, and with earnings of $1 per share last year this puts the P/E ratio at a lofty 25. Texas Roadhouse operates about 400 restaurants, and in 2012 recorded $1.26 billion in revenue. It seems that the company is being valued at a high multiple like many other small to mid-sized restaurant chains. But there's a big problem.

In 2011 Texas Roadhouse initiated a dividend, and in 2012 it paid 36% of its earnings out to investors. It has raised its dividend twice in the past year, and barring another increase will pay out $0.48 per share in dividends over the next year. Based on the average analyst estimate of $1.15 for 2013 EPS, the payout ratio for this year will be about 42%.

Not enough growth

For a company that only generated $71 million in net income in 2012, paying out over 40% of that as dividends leaves very little to invest back into the business. The second quarter of this year saw flat earnings on 10% revenue growth, and if this trend continues full year earnings could come in lower than analysts expect. This would lead to an even higher payout ratio and even less cash to invest back into the business.  

A dividend is an admission that management has nothing better to do with the money, and the aggressive dividend hikes so far lead to me believe that growth is going to slow down at Texas Roadhouse in the future. In 2013 the company expects to open 28 new restaurants, around a 7% store growth rate. With margins being compressed by higher food costs, earnings growth in the short term will be slow, with a longer term low-teens growth rate the best case scenario.

I don't know about you, but I find it difficult to pay 25 times earnings for a modestly-growing steakhouse that is spending half of its earnings on a dividend instead of on expansion. The stock price and the P/E ratio have become inflated, and I don't expect it to last.

A slew of competition

The steakhouse category is a crowded one, making expansion difficult and keeping margins low. The problem Texas Roadhouse is likely facing is finding locations that have a large enough population and aren't already saturated with competitors.  LongHorn Steakhouse, a chain with 430 stores and operated by restaurant giant Darden Restaurants , is roughly the same size as Texas Roadhouse with $1.2 billion in annual sales. In Darden's 2012 annual report the company states that it will build 37-40 new locations in the following year, quite a bit more than Texas Roadhouse. Darden believes that the restaurant could grow to between 600-800 locations, generating up to $2.5 billion in annual sales.

This goal likely also applies to Texas Roadhouse, and with the slower store count growth it will take longer to get there. Texas Roadhouse is not the type of company that will grow to thousands of locations, and investors seem far too optimistic about the future.

Darden also pays a dividend, but given that the company has brands such as Red Lobster and Olive Garden that provide consistent earnings and don't require much investment, it makes sense for the company to pay out a substantial amount of its earnings. After the dividend there is still plenty left over to fully fund concepts like LongHorn and build them quickly into national brands. Darden pays a massive 4.6% dividend, one of the highest in the restaurant industry, and is a great dividend growth opportunity.

Another steakhouse operator which recently started paying a dividend is Ruth's Hospitality Group . Ruth's is a small company that operates a handful of restaurant concepts, mainly steakhouses. In 2012 the company recorded about $400 million in revenue and $16 million in net income. The stock trades for about 27 times earnings.

Ruth's size apparently leads people to believe that fast growth is ahead, but the company isn't investing very much in its growth. For the last four years capital expenditures have been less than depreciation, not a characteristic of a fast growing company. In addition, just this year Ruth's started paying a small $0.04 quarterly dividend. The payout ratio based on 2012 will be about 34%.

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