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Evaluating an Industry
Course Section 3 - Lesson 3
In the last lesson, we found a stock, Texas Roadhouse, that had some attractive characteristics: It was operating profitably, growing, and its customers are fans of the brand. Now it's time to dig deeper; the first thing we want to understand is the industry in which the company operates.
Identifying Direct and Indirect Competitors
Most companies have layers of competitiveness with other products and services. If I want to watch a movie right now, several companies could help me satisfy that desire. Obviously, television manufacturers build devices that are capable of displaying movies. But so do computer manufacturers, and tablet manufacturers, and cell phone manufacturers. All of these devices potentially compete to deliver a movie viewing enabled device to consumers. When we evaluate a companies industry, while we want to be aware of the deeper layers of competition, we are primarily concerned with direct competitors: TV manufacturers in this case.
When we look at a company like Texas Roadhouse, they are obviously in the restaurant industry. But not all companies in this industry are direct competitors; for instance, if I offer to take my wife to dinner one evening, Texas Roadhouse may be an option, McDonald's likely will not.
Similarly, I used to work at a job that required a lot of travel. Some evenings, I would have a two or 3-hour drive to get home at the end of my day. If I were hungry during one of these late evening treks, It's unlikely I'd want to sit down for an hour-long meal at Texas Roadhouse. However, McDonald's provides just the sort of quick calories I'd need to satisfy my hunger and get me back on the road quickly.
Texas Roadhouse operates within a segment of the restaurant industry referred to as the Casual Dining segment. You discover this as you read the company's 10K filing. This segment sits above fast food in terms of service and price but below fine dining. A couple of google searches reveal that hundreds of restaurants operate in the casual dining space (see this Wikipedia article), but only a few are publicly traded.
Since privately-held companies don't report any business information, practicality says we should define the industry for Texas Roadhouse using a subset of publicly traded casual dining restaurants. For your reference, these companies are:
Texas Roadhouse, Inc. (TXRH)
Cracker Barrel Old Country Store, Inc. (CBRL)
Chuy's Holdings, Inc. (CHUY)
Brinker International, Inc. (EAT)
Bloomin' Brands, Inc. (BLMN)
The Cheesecake Factory Incorporated (CAKE)
Dave & Buster's Entertainment, Inc. (PLAY)
Red Robin Gourmet Burgers, Inc. (RRGB)
Denny's Corporation (DENN)
Darden Restaurants, Inc. (DRI)
Notice how this is not an exact science, nor does it need to be. When looking at industry and competitor data, we are attempting to draw general conclusions about the state of our target company's position in the industry.
Drawing High-Level Conclusions about the Industry
Now that we've defined the companies in our target industry, it's time to start drawing some conclusions. If you think back to Section One -Lesson Five of the course, two concepts were introduced:
The type of competition that companies faced, and
The stages of an industry life cycle
We want to begin by identifying each of these for our target company.
In this case, the type of competition that Texas Roadhouse faces is pretty clear-cut. There are hundreds of companies operating in the casual dining segment, ruling out monopolies and oligopolies, yet each restaurant can differentiate itself through its fare and environment. This differentiation among hundreds of competitors places restaurants firmly in the monopolistic competition category. Indicating that while restaurants have some control over pricing, that control is generally limited.
The industry life cycle for restaurants is also pretty straightforward. Restaurants have been around for hundreds, if not thousands of years. This industry has fully matured, and I would be unable to identify any reason it might have drifted through to the "Decline" phase. In aggregate, we are probably unlikely to see growth from the industry that is significantly greater than the growth of US Gross Domestic Product, or about 2-3% per year.
These two characteristics tell us a lot about what we should expect from an average investment in a restaurant stock. We will probably see relatively tight margins and relatively low growth unless our target company is a great operator, doing something innovative, or taking on a lot of financial risk (leverage).
Diving Deeper into Competitors
With these two questions answered, the next thing we want to determine is where our target company sits in the industry hierarchy. This involves some data collection.
Generally, what I want to know is, for every competitor we identified earlier, what are their total sales, what is the value of their company, and how profitable are they.
Collecting this data can be time-consuming if you do it by hand. But I've included a google sheets template in the course materials for this lesson that automatically aggregates this information by just entering a group of ticker symbols. Below is a screenshot of the document:
By filling out the template for the casual dining industry, we can see that (of the publicly traded companies) the industry generates about $20 billion a year in total sales. Of that total amount, Texas Roadhouse is responsible for about $2.3 billion. They are not a small player, but not the biggest either.
If we look at the market capitalization (or stock value of these companies), we see that the industry is worth about $42 billion or just over 2x revenue. What's interesting is here is that even though the average causal dining stock trades for ~2x revenue, Texas Roadhouse's stock is priced at 3x revenue. This is an early indication that either Texas Roadhouse is overvalued or they are generating far more value for investors than the average company in the industry.
Industry Knowledge Sets the Stage
This analysis of the industry may feel cursory, but it provides valuable context as we begin a deeper dive into the financial statements of our target company. In a very short period of time, we've established expectations for growth, margins and got a preview of pricing for casual dining stocks. We've also gained some insight into how the market views our target company, which appears to be favorable since it's priced at 1.5x the average stock in the casual dining industry.
For the remaining lessons in section three, we will be focused specifically on translating & analyzing the financial statements of our target company. We will, however, be coming back to take a closer look at the industry in section 4 when we tackle setting a price target for our company, Texas Roadhouse.