Why Labor Cost Worries at Texas Roadhouse Are Overdone

After an epic run over the last decade, casual dining chain Texas Roadhouse (TXRH 1.41%) is facing its first real setback since the financial crisis of 2008. The stock is down nearly 30% from the all-time high it set in late 2018.

It's not for lack of diner interest. On the contrary, the steakhouse continues to be one of the best-performing restaurants out there when it comes to sales. Rather, the issue has to do with expenses -- specifically those pertaining to labor and wages. Concerns over those increases may be overblown, though.

When higher sales equal contraction

For an established chain like Texas Roadhouse, comparable store sales (a combination of foot traffic and average guest ticket) is one of the most important metrics for driving profitable gains. In this department, the steakhouse has performed admirably -- especially considering overall lackluster gains in comps for the U.S. restaurant industry. In 2018, comps increased 5.4% at company-operated locations and 4.3% at franchised ones. To kick off 2019, comps grew another 5.2% and 4.3% at company-operated and franchised stores, respectively.

Image source: Texas Roadhouse.

With most of the company's 564 domestic stores now well established, it's no surprise that the rise in comparable stores equated to a 10% increase in revenues. Management expects that positive momentum to continue throughout the year, and the couple dozen new locations that will cut ribbons this year should add to that. Nevertheless, operating income and earnings per share fell 6.8% and 8.1%, respectively, during the first quarter of 2019.

Blame for this can tied to wage inflation, a problem that began to crop up in the second half of 2018. The top team at Roadhouse expects higher wages to continue to pressure the bottom line for the foreseeable future, especially in the short term as it outpaces growth in total sales. Full-year wage expenses were updated to be 7% to 8% higher than last year.

Data source: Texas Roadhouse. YOY = year over year. 

One overcooked stock

Here's the good news: after a 14% surge in the first quarter, a full-year wage hike of 7% to 8% would imply a slowdown in pay increases later on in the year. With those costs moderated, a rebound in earnings could be in the cards if comparable restaurant sales stay on their present positive trajectory.

Plus, higher wages in the general populace over the long term means consumers have more money to spend. For a chain like Roadhouse that has been winning with diners for some time, that can only mean positive things. Management would agree. Company president Scott Colosi said this on the last earnings call: "With our proven track record, we feel good about weathering any storm by remaining committed to and focused on the fundamentals that have got us to where we are today. We believe we are on our way to growing our average unit volumes to $6 million over the coming years, and are confident that profit growth will follow."

Average annual store sales volumes are roughly $5 million today, so $6 million is quite the ambitious goal. Investors will want to monitor progress on this in the years to come. Between now and then, though, a competitive labor market means hiring talent will be expensive. But those headwinds should begin to subside as Roadhouse laps some of the big wage hikes over the summer months. The steep stock sell-off over labor looks overdone to me.