Don't Mess With Texas

Chad is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Some of my favorite investments are companies that offer both growth and income. The great thing about these types of investments is investors get the best of both worlds. Generally speaking, these are companies that are already established enough to feel confident in returning some of their profits to shareholders. However, once in a while I'll find a company that is still growing at a respectable rate, and yet pays a good dividend as well. This is the type of opportunity available to investors in Texas Roadhouse (NASDAQ: TXRH). The company is growing at a good pace, but is also committed to returning profits through dividends as well.

In the restaurant industry there are no shortage of competitors. However, just like Peter Lynch I tend to follow a lot of restaurants because they are easy to track, and easy to understand. To be a good investment, a restaurant needs to establish a successful formula and then replicate it over and over again in different locations. In general, you want to see positive same-store sales, and a slow but steady approach to opening new locations. Since a big problem with restaurants that expand too fast is too much debt, investors should also look for companies that aren't too leveraged. When it comes to well established restaurant companies, most investors are quite aware of Brinker International (NYSE: EAT) and Darden Restaurants (NYSE: DRI). Between the two companies, they have some of the most well-known chains in Chili's, Red Lobster, and Olive Garden. Each company also offers strong competition to the likes of Texas Roadhouse as they have better name recognition and similar growth and income profiles. That being said, Texas Roadhouse also has to compete against other fast growing concepts like Buffalo Wild Wings (NASDAQ: BWLD), which offers a casual dining experience along with television coverage of major sporting events. Since customers can theoretically choose any of these restaurants, Texas Roadhouse has to offer something compelling to keep customers coming back.

If the company's recent quarter is any indication, diners keep coming back and as Texas Roadhouse expands, more diners will become aware of the chain. The company prides itself in hand-cut steaks and fresh baked bread. In the recent quarter, the company grew revenue and diluted EPS by 15%. Same-store sales were also strong at both company-owned and franchised restaurants showing increases of 3.6% and 4.9% respectively. This strong performance also translated into strong cash flow growth as operating cash flow increased by nearly 14%. Texas Roadhouse also improved its balance sheet by increasing cash and cash equivalents by over 14%, and paying down long-term debt by over 16%. Since this all sounds like positive news, what can the company do to improve?

There are two areas I noticed the company can improve on. First, the company has room to expand its operating margin. Looking at its competition, Texas Roadhouse is already outperforming several by this measure. For instance, Buffalo Wild Wings is still trying to improve its own operations and shows an operating margin of 7.39%. Darden Restaurants is far more established, but has struggled to make the Red Lobster chain more relevant and this has weighed on its operating margin of 8.56%. The class leader is Brinker, which reported a margin of 9.38% in their most recent quarter, versus Texas Roadhouse at 8.99%. While this doesn't seem like much of a difference, Texas Roadhouse needs to always work toward being more efficient. The second area the company can improve on is that of managing the desire to return profits to shareholders and making sure this doesn't become a detriment to future growth.

Texas Roadhouse pays a yield of about 2.1%, but in the recent quarter this equated to a 62.28% free cash flow payout ratio. While this payout ratio isn't dangerous yet, compared to its dividend paying competition this is a bit high. For instance though Darden pays the highest yield, in the company's most recent quarter they used just under 17% of their free cash flow on dividend payments. Brinker pays a just slightly higher yield than Texas Roadhouse at 2.58%, but their free cash flow payout ratio is lower at 41.35%. What is interesting is Brinker, Darden, and Texas Roadhouse are all expected to grow earnings by 11% to 13.5%. All three companies pay dividends, and all three pay a yield of at least 2%. However, faster growing competition like Buffalo Wild Wings has chosen to keep its cash towards faster expansion. Since analysts expect the company to grow earnings by 20% going forward, one might make the argument that Texas Roadhouse should be careful to not trade dividends for faster growth.

Overall, Texas Roadhouse looks like a good combination of growth and income. As long as the company can appropriately manage their dividend payments versus funding for future growth, investors should seriously consider the shares. The company expects to open a total of 25 new restaurants in 2012, which represents roughly 7% new store growth. The company expects to expand its store growth to 28 new stores in 2013, which would indicate about 7.27% new store growth next year. With new store openings speeding up, and positive comparable store sales expected, 2013 should be another great year for this Texas sized value.

MHenage has no positions in the stocks mentioned above. The Motley Fool owns shares of Buffalo Wild Wings and Darden Restaurants. Motley Fool newsletter services recommend Buffalo Wild Wings. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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