In the Chairman’s letter written to the shareholders of Berkshire Hathaway (NYSE: BRK-A) (NYSE: BRK-B) in 1995, Warren Buffett explained why retailing can be a tough business. He likened it to a “shooting-star phenomenon,” where not taking care of day-to-day details can lead to failure. He also explained that consumers are always tempted to flock to a new store offering fresh and exciting merchandise.

His specific reference was to furniture giant R.C. Willey, which Berkshire acquired that year. However, the restaurant business is almost identical to furniture retailing and can actually be considered a subset of retailing. But instead of merchandise that may include furniture, clothing, or housewares, the products sold are food, beverages and friendly service.

The best case scenario for finding appealing restaurant stocks is locating a concept that is newer and a management team that knows how to consistently execute managing its restaurants. Buying the stock at an appealing price is also a key ingredient to making above-average returns.

By my estimates, steakhouse chain Texas Roadhouse (Nasdaq: TXRH) possesses these key characteristics. The company is very young compared to rivals: it was founded in 1993, operates in 46 states, but its current store base of 345 restaurants is small compared to rivals. For comparison purposes, Darden Restaurants (NYSE: DRI) was founded in 1968 and currently operates 1,800 restaurants, primarily via the Red Lobster and Olive Garden names. Brinker International (NYSE: EAT) was founded in 1975 and runs 1,550 locations, primarily under the Chili’s and Maggiano’s franchise names.

Brinker has been selling off older restaurant concepts to try and keep growth trends in a positive direction. In recent years, it has sold of its Macaroni Grill and On the Border restaurants and shifted gears to Maggianos, which is a newer Italian restaurant concept out of Chicago. Unfortunately, Brinker is still struggling. Sales have fallen 6% annually in the past five years and are now less than $3 billion. Profit growth has been positive and recently came in at $138 million, or $1.34 per share, but is still uninspiring, at 3% annually growth in this same five year period.

Darden has done a much better job at keeping its restaurant concepts fresh in the eyes of consumers. It frequently remodels stores, keeps its menu items current and affordable, and opens new stores at a modest clip. As a result, annual sales have advanced at about a 5.5% annual clip to a recent $7.5 billion and profits at more than 9% annually over the past five years to a recent $476 million, or $3.39 per share. This is steady, but rather unexciting growth.

In contrast, Texas Roadhouse has plenty of room to grow. It’s casual steakhouse concept has caught on, allowing management to grow sales and profits at an extremely robust double-digit rate during the past five years. Specifically, sales are up 17% and profits nearly 14% annually in this time frame. Last year, sales reached $1 billion last year, up from $459 million in 2005. Net income grew to $58 million, or $0.80 per share, from $30 million, or $0.42 a share in 2005. Last year’s free cash flow generation was even stronger than reported net income at $75 million, or about $1.03 per share.

For the coming year, analysts project sales growth of 10% and total sales of $1.1 billion. The current earnings projection is $0.85 per share, which represents growth of about 6% compared with last year’s $0.80 in earnings. Management expects profit growth between 5% and 10% for the year and expects to open 20 new stores throughout its fiscal year. Investors found the company’s current guidance disappointing because it fell below analyst expectations. As a result, they sent the share price down sharply.

Despite the near-term disappointment, Texas Roadhouse’s future remains extremely bright. Its success is also due in good part to the fact that management knows how to execute. A recent company presentation to investors detailed that Texas Roadhouse receives very high guest satisfaction grades: 90% of customers surveyed said they planned to eat at Texas Roadhouse again. Olive Garden was the next highest at 84%, while Chili’s came in eighth at 74%.  Additionally, store managers must invest their own money in each restaurant, which motivates them and aligns their interests with shareholders. 

Action to Take –> Given the recent market weakness and disappointing near-term profit guidance, Texas Roadhouse’s price-to-earnings (P/E) ratio has fallen to 16.6. Its trailing free cash flow multiple is an even lower 13.6. To put this in context, these multiples were as high as 30 five years ago. These are very reasonable multiples given the company continues to grow sales and profits in the double digits.

Management’s goals are to grow both sales and earnings in the low teens, percentage-wise, annually. It believes this will result in total annual shareholder returns in the mid-teens, which adds in a current dividend yield of about 2%. The company has also paid down debt and bought back its own stock with excess about $45 million in free cash flow in the past three years. It sees the potential for 1,000 eventual locations across the country, which suggests at least another decade of double-digit growth for loyal shareholders.

By my calculations, if Texas Roadhouse grows cash flows by 15% each year during the next decade, then the stock will be worth in excess of $21 per share, or about 50% above current levels. It won’t be easy. Management will have to stay focused and fend off newer competitors, but the execution is there and the concept still has plenty of real estate to expand into in the coming years.

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