Legendary To Core

Source: Texas Roadhouse

Texas Roadhouse (NASDAQ:TXRH) is a family restaurant chain specializing in hand-cut steaks at affordable prices. Its market cap is below $3 billion, but the company has spread to 49 states along with a few international locations.

Management has been able to deliver value to shareholders by doing things differently from Texas Roadhouse's casual full-service restaurant competitors. In the past year, the stock is up around 50%, yet it still has market-beating potential. 

Geographic focus on secondary and tertiary markets
In cities like New York City, Chicago, and Dallas, there are plenty of wonderful upmarket steakhouses, with prices to match. Fixed costs such as rent and labor are higher in these areas, and it's difficult for a value-focused restaurant to compete while serving the same genre of food. For chain restaurants to survive in dense metro areas, they often must charge much higher prices than they do at their other locations. Texas Roadhouse has therefore chosen to focus exclusively on secondary and tertiary markets.

There are a plethora of opportunities for restaurants in markets outside metro hubs, and this has been Texas Roadhouse's bread-and-butter growth strategy. There are no Texas Roadhouse restaurants in Dallas proper, for example, but they're scattered all around the city's outer bounds, where real estate is cheaper and they can be profitably operated with lower menu prices.

Focusing on the areas that the more upmarket companies leave unserved gives Texas Roadhouse an advantage in site selection and a clear roadmap for growth. 

Restaurant managers' incentive to excel
In the restaurant business, company-owned locations generally have a few benefits over franchised locations. The profits derived from the store all go back to the company rather than just franchise fees. In a well-run location, this can be a significant difference. Quality control is improved and consumers receive a more standardized experience, which helps to reinforce brand image.

Franchised locations have the benefit of incentivizing operators to work extremely hard and offer new ideas for products and initiatives as the performance of their location has the biggest effect on their income.

Texas Roadhouse locations are overwhelmingly company-owned -- 372 of its 451 locations were company-owned as of the end of 2014. However, Texas Roadhouse has developed a hybrid model where most of the profits return to the corporate coffers but managers still have a great incentive to have their locations performing at peak operational efficiency.

From the 2014 annual report: "We offer a performance-based compensation program to our individual restaurant managers and multi-restaurant supervisors, who are called 'managing partners' and 'market partners,' respectively. Each of these partners earns a base salary plus a performance bonus, which represents a percentage of each of their respective restaurant's pre-tax net income." 

With a base salary starting at $45,000 and a performance bonus of 10% of the store's net income, the average managing partner's total compensation is greater than $100,000 per year. This is without the initial capital outlays and recurring fees usually paid by franchisees. This setup is a good way to attract great managers and keep them highly motivated.

C-suite and board aligned with shareholders
Senior Texas Roadhouse executives and directors are all required to hold a certain amount of stock in the company. Specifically: "Our Chief Executive Officer should own, at a minimum, the lesser of 100,000 shares or $2,500,000 in then-current market value."

I like when the people running the companies I invest in have some skin in the game along with me. This requirement is a good start, and concerns over failing to reach the minimum requirements should never come into play here, with CEO and founder W. Kent Taylor owning over 6 million shares and nearly 9% of the company. 

Boring, but executing well
This is not an investment that's going to make you a celebrity at a cocktail party or make you rich overnight. It does pay a dividend, which it instituted in 2011 and has raised every year since then. The stock currently yields nearly 1.8%, even after the recent run-up.

The company is run by proven capital allocators. Since 2008, management has repurchased "a total of 14,408,362 shares of common stock at a total cost of $201.0 million through December 30, 2014." That comes to a per-share price of just under $14. With the stock currently trading for nearly $40 and a net cash position on the company's books, it's hard to argue that this was not a prudent use of capital. 

The company is looking to add 25 to 30 new locations in 2015 and is on pace for positive same-store comps as well. Revenue has grown at a compound annual rate of 15.86% over the past 10 years. Net income growth has been nearly as robust, at 14.90%. 

Valuation a bit high ... but don't run!
Texas Roadhouse's forward P/E is 23.3, compared with 18.3 for the S&P 500 and 20.6 for its own five-year average. That's a little high, but I think the current valuation is justified. Management has found a great growth niche, gives employees an incentive to perform to the best of their abilities, and has proved to be a good steward of shareholder capital.

While I don't expect another 50% gain in share price in the next year, a 1.8% and growing dividend, smart share repurchases, and net income growth in the high single digits should deliver potentially market-beating returns over the long run.

James Sullivan owns shares of Texas Roadhouse. The Motley Fool recommends Texas Roadhouse. 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.