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At the moment, perhaps the biggest reason to believe a recession is not around the corner is that seemingly everyone in the financial markets is predicting one. That aside, the US economy looks like it’s headed for potentially big trouble.

Indeed, we may already be in big trouble:

source: Atlanta Fed

Obviously, the equity market has been discounting an economic downturn for quite some time. The declines that began early last year in the most speculative growth stocks were driven by bubbly valuations. While valuations clearly were stretched across the market at the highs, the 2022 sell-off looks more like a realization that even the biggest, best, U.S. corporations have been overearning:

source: YCharts. Chart since 1/1/2021

The S&P 500 has declined 20.6% so far in 2022, its worst first-half performance in more than 50 years.

Cyclical stocks and sectors have done even worse. The SPDR S&P Homebuilders ETF (XHB) and the iShares U.S. Home Construction ETF (ITB) both are down 34% year-to-date. The SPDR S&P Retail ETF (XRT) is off 35%; the SPDR S&P Semiconductor ETF (XSD) 40%.

In other words, the obvious macro shorts for the most part have already fallen sharply. To be sure, that doesn’t mean there isn’t more downside ahead, but the easy money has been made.

Casual-dining chain Texas Roadhouse (TXRH), however, has declined just 16% despite operating in an industry which seems among the worst possible business models for a worst-case macro scenario. And so, for investors looking to bet on that scenario — or to hedge against that risk — TXRH stock looks like an attractive short.

The Case Against Shorting TXRH

For a short like this, it’s worth considering the risks first. The most obvious is that, in fact, the economy doesn’t roll over. There’s certainly an argument that much of the negative data at the moment is in varying ways a reflection of an unprecedented environment, rather than the beginning of a multi-quarter negative trend.

High inflation is being driven to some degree by supply chain issues, a shrunken labor force, and an oil supply shock driven by the Russian invasion of Ukraine. GDP growth for Q2 2022 looks awful; but real GDP rose 6.7% in Q2 2021; the two-year stack paints a far less grim picture.

Meanwhile, the consumer seems to be still reasonably strong, and household balance sheets remain in solid shape:

source: Federal Reserve

We’ve been reasonably consistent in taking a more pessimistic view. Six weeks ago, we recommended investors short boating stocks, in part due to macro concerns (though industry-specific factors played a larger role). Last month, we highlighted the possibility (emphasis on “possibility”) of a dire multi-year outcome for both the market and the economy.

In that scenario, this sell-off is not 2000 or 2008, but 1970: the last time the market performed so poorly in the first six months of a year. Total nominal appreciation for the S&P 500 over the next twelve years — twelve years! — from that point was 49%. Real returns even including dividends were essentially zero on an annualized basis.

From here, the positive data that exists appears mostly backwards-looking. And the nature of an economy (as so brilliantly explained by South Park in 2009) depends on confidence. The fact that everyone expects the economy to turn does in fact make it more likely to do so. But it’s possible that we, and so many others, are wrong. A short of TXRH has to assume we are not.

The second risk is that Texas Roadhouse manages through the difficult environment and continues to grow earnings. It’s worth noting that the company already has done so. In 2008, same-restaurant sales declined 2.3%; operating income fell just 1.9%. In 2009, despite another decline in comps (-2.8%), operating margins increased 110 bps, and at 8.1% were only 50 bps below the 2007 figure (and 100 bps below the true boom days of the year before). In fact, thanks to a strong pace of restaurant openings, operating profit actually grew rather nicely between 2006 and 2009.

Along those lines, Texas Roadhouse has managed through the challenges so far. In Q1, Texas Roadhouse dealt with commodity inflation of 17%, with wages up more than 10% per the Q1 call. Restaurant margin dollars still rose more than 9%; adjusted earnings per share increased 19% year-over-year.

Meanwhile, beef price inflation is moderating; labor may do the same. The company after Q1 forecast full-year commodity inflation of 12% to 14% and wage/labor around 7%, which suggest a sharp deceleration from Q2-Q4 (~11% and ~6%, respectively).

Texas Roadhouse also has room for further expansion from here — the same expansion that kept profits rising during the financial crisis. The company plans store-count growth of about 25 units this year, between its namesake chain and its Bubba’s 33 sports-themed nameplate.

It’s worth noting, too, that this has been an excellent business over time: between 2008 and 2021, net income rose more than 6x, an annualized growth rate over 15%. The stock has returned about 20% annualized since the start of 2010, one of the better performances in the entire market. Outback Steakhouse owner Bloomin’ Brands (BLMN) has posted total returns of just 53% since its 2012 IPO. Its customers are loyal, the experience (in my limited visits) is solid, and the rolls are so good that tons of websites offer “copycat” recipes.

With just $100 million in debt, and thus significantly less interest expense than peers — particularly larger casual-dining players Darden Restaurants (DRI) and Brinker International (EAT) — perhaps Texas Roadhouse can muddle through better than its rivals.

The Valuation and Margins Catalysts

Were it a year ago, there would be a stronger case for not shorting a business that seems to be rather high-quality. But, again, there simply aren’t nearly as many macro-based short opportunities out there.

Meanwhile, even down 16% YTD TXRH stock is pricing in a rather high likelihood of muddling through — or more. Shares trade at 20.5x trailing twelve-month earnings.

Operating margins over that stretch were a bit over 8.3%. In 2019, they were 7.7%; the year before, 7.6%.

At the very least, there’s not much argument for the idea that the environment of the past four quarters has been notably negative for margins. Yes, inflation has been significant — but revenue growth has offset that.

Indeed, in 2021, restaurant labor expense was 32.7% of sales — against 33.1% in 2019 and 32.6% the year before. Restaurant cost of sales were 33.6% last year; the figure was 32.6% in 2018 and 32.8% in 2017. Q1 2022 was a bit of an outlier in terms of inflation relative to 2021, but margins still came in at 9.1% against 10.1% in the year-prior quarter.

In other words, profit margins still are at peak levels relative to post-crisis/pre-pandemic performance. The core reason that Texas Roadhouse has been able to keep peak margins despite inflation has been the strength of its customers. That strength has allowed for menu pricing increases and for higher tickets beyond inflationary effects.

What happens when that customer strength finally recedes? One obvious answer is that margins recede. Texas Roadhouse positions itself as a reasonably-priced steakhouse option; its average check in 2021 was just under $20, per the 10-K. That positioning — “where the working man can get a steak dinner” — comes under fire when that check inflates into the mid-$20s. It leaves Texas Roadhouse with the choice of either giving up margins or sacrificing sales.

Even in a muddling through scenario, there’s probably still some margin compression. Move from the trailing twelve-month 8.3% to 7.5% and the P/E multiple now looks to be around 23x. As noted, even that mid-7% figure is about where it was in the far more benign environment of the late 2010s (though labor admittedly was an issue in 2019). There’s an obvious scenario where margins start with a ‘6’ or worse, in which case EPS is dipping below $3 even if sales hold up. If ‘stagflation’ returns, the combination of lower sales and compressed margins suggests room for a very sharp decline.

And at 20x earnings, there’s not a ton of room for investors to take the long view and (as they should in theory) expand the multiple to account for trough profits. (That assumes that a decline from here necessarily represents trough profits.)

The jackpot scenario for a short here is flattish sales, even with restaurant openings; 100 bps-plus of margin compression; and a multiple that moves from 20x to the mid- to high-teens. That scenario suggests the stock gets to the $45-$50 range, something like 30-40% downside for a business whose lack of balance sheet leverage mitigates some of the upside risk relative to other cyclical bets.

The Earnings Catalyst

The old saw is that shorting based solely on valuation is a fool’s errand. Shorts, the theory goes, need a near-term catalyst.

Whether that saw is necessarily correct is unclear; it certainly hasn’t been over the past 17 months. But there is a potential catalyst here: growth is about to look much less impressive.

As noted, Q1 earnings looked impressive, with EPS up 19% year-over-year. But the year-prior comparison was also much lighter. Those comparisons get steadily tougher as this year goes on, given the general return to normalcy that accompanied most of 2021.

Between Q1 2019 and Q1 2021, revenue rose 16%; income from operations climbed 34%. For Q2 2021, two-year growth rates were 30% and 68%, respectively. Indeed, analysts on average expect earnings to decline about 6% year-over-year in Q2.

It’s hard to see how a restaurant stock holds a 20x-plus multiple if earnings post a decline — no matter the environment. There’s an argument that the market should understand the coming pressures, and that to some extent those pressures almost have to be priced in — particularly in a bear market.

Perhaps. But betting that bulls are taking the long and broad view, or that the market (and this market!) isn’t going to make a knee-jerk reaction to earnings, is precisely how so many of us have missed so many short opportunities so far. At the very least, if there’s a quarter or two of earnings declines ahead (and consensus implies y/y declines for the remainder of this year), it’s hard to see the stock rise from here.

The Bullish Catalysts

It’s worth circling back to the initial case against shorting the stock, and how Texas Roadhouse managed to grow total profit from 2006 through 2009. Again, the core reason was restaurant growth — and Texas Roadhouse admittedly still is growing its footprint.

But the problem from the long side is that the unit growth is essentially the same — and thus far less impactful. In 2007, Texas Roadhouse added 41 locations, increasing its count by 25%; the following year, net growth was the same, a more than 20% increase.

This year, across the three concepts (TXRH also has a Jaggers fast food brand), the company is adding 25 locations, plus seven franchises acquired in January. That’s a less than 6% increase from the 566 at the end of 2021.

Those additions also are getting far more expensive, thanks to construction inflation. Texas Roadhouse locations now cost about $6 million; Jaggers about $7.5 million. Indeed, the company is guiding for capex around $230 million this year, which implies free cash flow that will come in at barely half consensus earnings.

Longer-term, Bubba’s and maybe Jaggers (something along the lines of Shake Shack (SHAK)) have real value. Permitting and labor delays have slowed the pace of expansion for the company this year.

But the bet here is precisely that the market is heading to a point where it’s not going to take the long view. It’s going to see a cyclical restaurant business facing margin compression and a slowing, if not reversing, top line — and it’s going to sell the stock off hard.

That’s how almost every other cyclical in the market has been treated over the past few months. Unless something changes — and we don’t believe it will — it’s how TXRH will be treated as well.

Vince Martin has no positions in any securities mentioned. He may initiative a short position in TXRH this week.

Tickers mentioned: TXRH

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