Saved by the Cow

Ruth’s Hospitality Group (RUTH) reported earnings this morning. The operator of Ruth’s Chris Steak House provided a good summary of many of the macro trends I documented during the most recent earnings season.

First, the consumer remains stubbornly sluggish. On their conference call management stated, “The pace of the consumer overall feels very much the same.” Company-owned stores reported flat same-store sales during Q4. Same-store comps were aided by higher average check growth of 2.3% (1.6% pricing). Traffic declined 2.2%. This is a subject I’ve addressed in recent posts. I believe a better measure of consumer demand is volume and traffic, not same-store comps that are often aided by mix and price. Comps excluding price and mix will be especially important to monitor in a more inflationary environment.

Another theme I’ve documented this quarter has been rising costs. Labor inflation was noticeable at Ruth’s Chris this quarter and year. Specifically, the company’s operating expenses as a percentage of sales increased 30 basis points, “primarily due to an increase in labor expense.” On their conference call, management stated they expect another year of fairly significant labor inflation with last year’s wage inflation increasing 4-5%.

There were some bright spots on expenses. Food and beverage costs declined 180 basis points, with beef costs declining 6.4%. As you can see from the chart below, the decline in beef prices appears to be over. Management also noted this deflationary benefit may be ending, stating certain steak cuts are up 6-9% year over year. That said, the company is expecting their overall commodity basked to be manageable next year.

Cattle Futures Chart

When determining normalized cash flows, it’s important to consider how fluctuating input costs influence profit margins. What is the company’s possible margin range and what costs influence that range? Similar to earnings, costs of a business have their own cycles. It’s important to know these cycles in order to properly determine a company’s normalized margins and cash flows. For example, I’d be reluctant to extrapolate Q4 beef costs when calculating Ruth’s normalized margins.

As a reminder, calculating accurate normalized margins is essential in developing an accurate business valuation.  Having a high degree of confidence in a business’s value is also essential to my absolute return process and discipline. Without valuation confidence, it’s difficult to act opportunistically and decisively – decision making becomes erratic and foundationless. Furthermore, accurate valuations can help limit mistakes and permanent loss to capital.

In conclusion, Ruth’s Chris’s profit margins have benefited from lower beef costs — a trend that appears to be reversing. Furthermore, earnings and same-store comps were aided by the company’s ability to raise prices. While same-store sales comps are important, I believe the quality of comps (traffic, volume, mix, and price) should also be carefully considered. Similar to what I’ve noticed with many businesses this quarter, deflationary benefits that aided margins in the past are now reversing. Labor costs are also a growing issue and do not appear to be transitory.

Going forward, I believe it’s going to be increasingly important for investors to monitor costs and the associated impact on margins. It will be interesting to see if investors have properly taken rising costs into consideration when making their margin assumptions. In effect, have investors been extrapolating or normalizing this profit cycle? I’m looking forward to finding out.

Have a great weekend! As Ruth’s management said at the end of their call, “As always, it’s a great day to go out and eat a steak.” Sounds good to me!