Do You Expect Too Much From This Stock?

Gaurav is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

It is the best of the times and it is the worst of the times. This is the story of Panera Bread (NASDAQ: PNRA), one of America’s most loved bakery chains.

Panera is combating an unfavorable economy and flat-to-declining restaurant visits across the country. Meanwhile there is an increasing tilt towards eating healthy, which is brightening its prospects. So, where does the company stand?

High expectations

Panera has grown its revenue from $1.3 billion in 2008 to $2.1 billion in 2012 and its earnings per share have increased by more than 24% for the last five consecutive years. So, expectations run high.

In its first quarter, although Panera increased its revenue by 13% year-over-year to $561.8 million and its earnings by 17% to $48.1 million, or $1.64 per share, both fell short of expectations. Analysts had predicted earnings of $1.65 per share on revenue of $566.3 million.

For the full year, Panera is looking at 17% to 19% growth in earnings per share, which translates into between $6.89 and  $7.00 per share. But analysts expect no less than $7.04 per share. Meeting or beating this will not be easy for Panera given the challenges involved.

Challenges

Panera has to deal with a weak restaurant environment and a horde of competitors that equally want to cash in on the eating-healthy trend. In April, researcher NPD Group predicted that traffic in the fast-food sector will slide by 1% in 2013, while overall restaurant traffic remains flat. In this backdrop, Panera is targeting same-store sales growth of between 4% and 5% in 2013.

On the competitive front, the chain’s biggest threats come from Chipotle Mexican Grill (NYSE: CMG), which also has healthy food as its unique selling point, and Starbucks (NASDAQ: SBUX), which has acquired the bakery cafe La Boulange to strengthen its food offerings.

Chipotle’s excellent Mexican fare made with premium quality meat has set its popularity soaring. The chain expanded to 1,410 stores in 2012 and is opening another 170 this year. But, it is not immune to competitive pressures and saw its comps dip by 1% in the first quarter.

Not a candidate to be beaten, it is braving competition with new menu offerings like the tofu based ‘Sofritas’ that may soon go for a national launch, and Patron Margaritas. However, Chipotle may have to raise its prices this year, something that it has not done in the recent past. It remains to be seen how customers react to this.

Starbucks is obviously a formidable rival, which could grow its same-store sales by an incredible 7% in the US in its most recent quarter. And this behemoth is now concentrating on food in order to optimize the ratio between its food and drinks orders. Currently, two-thirds are still beverages.

It is testing La Boulange offerings in around 439 stores in the San Francisco Bay Area and plans to have a complete roll-out in all company-owned stores by 2014 year-end. The sandwiches and biscuits on the offer can be a big threat to Panera.

Panera’s strategy

To beat the odds, Panera is exploring new markets and adding restaurants there. It is also spending more on promotions and pepping up its menu offering.

Expansion

Panera is a relatively new name and can grow in non-penetrated markets. In New York alone, it arrived just about a couple of years back and is planning to open more restaurants in Manhattan. Panera is adding a total of 115 to 125 stores this year. At March-end, there were 1,673 stores of which about 49% were company- owned.

The company sees high returns on its invested capital and has started owning more of its restaurants. Panera has worked out that it takes roughly $1 million to open a new store and average sales per restaurant are around $2.4 million annually. With a 20% margin, this is approximately an EBITDA of $500,000 and an ROIC of 50%.

In 2003, company-owned stores accounted for 23% of system-wide stores and generated $266 million in revenue. Now, almost half of the stores are owned by Panera and they generated sales of approximately $1.9 billion in 2012.

Creating market buzz

Panera has recently launched its “Live Consciously, Eat Deliciously” campaign for tapping the healthy eating trend further. It has increased its marketing budget for the year to around 1.6% of sales compared to 1.3% and 1.4%, respectively, in the last couple of years. This indicates about a 30% year-over-year increase in actual dollars spent this year.

The other big initiative gaining popularity is the loyalty program ‘MyPanera.’ Since its launch in 2010, the chain has collected 13.8 million members, which is providing the company an excellent platform for one-on-one marketing.

Panera Cares Café

However, the company’s biggest brand-building initiative to date has been the launching of ‘pay-what-you-can’ stores known as Panera Cares Café. Here there are no bills; the customers are told the indicative price of their orders and it is up to them to ‘donate’ what they want.

Panera has five such cafes and these locations are all self-sustaining, thanks to its strategic positioning in areas where it attracts crowds from mixed income groups. Trends show that 20% of customers pay more than the suggested donation, 60% pay the suggested donation, and only 20% leave less.

Now Panera is taking the concept to a new paradigm and is testing a new Turkey Chilli in Bread Bowl as a pay-what-you-can item in all of its regular stores in St. Louis. Depending on the program's success, this may go for a national launch sometime. If that happens, we would definitely see some interesting comps.

New offerings

Customers have already marked Panera for its soups, sandwiches, and salads. To further strengthen its lunch and dinner options, the company launched its pasta menu a couple of months back. And the response has been good.

It has also added new seafood items in the form of a Shrimp Salad Roll, its Lobster version, and also a Chilled Shrimp and Soba Noodle salad. In the specialty drinks category, the chain has added a new Frozen Cherry Limeade and in desserts it has introduced Strawberry Rhubarb Mini Cake.

These new items should improve restaurant traffic and boost same-store sales growth.

Final verdict

Despite the recent run-up in the stock price, we find that Panera has a P/E ratio of 30.3. While this may seem high, it is still cheaper than both Chipotle and Starbucks, which have P/E ratios of 39.5 and 33.3, respectively. All three companies are pursuing expansion plans and making their menus more attractive. Their premium multiples arise out of their strong growth prospects.

Panera is also investing heavily in expansions, promotions, brand building initiatives, and quality menu options to keep its growth trajectory unimpaired. It is likely to match its performance with everything that the analysts expect and outperform the broader fast-food sector. This justifies the valuation that it is commanding and offers more upsides to investors.

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Gaurav Basu has no position in any stocks mentioned. The Motley Fool recommends Chipotle Mexican Grill, Panera Bread, and Starbucks. The Motley Fool owns shares of Chipotle Mexican Grill, Panera Bread, and Starbucks. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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