Panera Bread (PNRA) may be the healthy alternative to fast food, but will its stock returns be as healthy? Let's dig into the investment prospects of the firm.
But first, a little background to help with the understanding of this article. We think a comprehensive analysis of a firm's discounted cash-flow valuation and relative valuation versus industry peers is the best way to identify the most attractive stocks at the best time to buy. This process culminates in what we call our Valuentum Buying Index, which ranks stocks on a scale from 1 to 10, with 10 being the best. Valuentum followers have read the "12 Steps to Understand the Stock Market" and believe the more investors interested in the stock, the greater likelihood for future capital appreciation. More interest = More buying = Higher stock price. Essentially, we're looking for firms with characteristics that overlap investment methodologies, thereby revealing the greatest interest by investors (we like firms that fall in the center of the diagram below).
If a company is undervalued both on a DCF and on a relative valuation basis, it scores high on our scale. Panera Bread posts a VBI score of 6 on our scale, reflecting our "fairly valued" DCF assessment of the firm, its neutral relative valuation versus peers, and very bullish technicals. We compare Panera Bread to peers McDonald's (MCD), Starbucks (SBUX) and YUM Brands (YUM). In the spirit of transparency, we show how our performance has stacked up versus peers below:
Our Report on Panera Bread
• We like Panera's positioning as a healthier alternative to traditional fast food, and we think the company's updated stores provide a great atmosphere to invite consumers to trade down from casual restaurants.
• Panera Bread's business quality (an evaluation of our ValueCreation™ and ValueRisk™ ratings) ranks among the best of the firms in our coverage universe. The firm has been generating economic value for shareholders with relatively stable operating results for the past few years, a combination we view very positively.
• Panera Bread has an excellent combination of strong free cash flow generation and low financial leverage. We expect the firm's free cash flow margin to average about 8.4% in coming years, and the firm had no debt as of last quarter.
Economic Profit Analysis
The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital (ROIC) with its weighted average cost of capital (WACC). The gap or difference between ROIC and WACC is called the firm's economic profit spread. Panera Bread's 3-year historical return on invested capital (without goodwill) is 34.5%, which is above the estimate of its cost of capital of 10.8%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT. In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid gray line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Panera Bread's free cash flow margin has averaged about 7.9% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. At Panera Bread, cash flow from operations increased about 22% from levels registered two years ago, while capital expenditures expanded about 85% over the same time period.
Our discounted cash flow model indicates that Panera Bread's shares are worth between $146.00 - $220.00 each. The margin of safety around our fair value estimate is driven by the firm's LOWValueRisk™ rating, which is derived from the historical volatility of key valuation drivers. The estimated fair value of $183 per share represents a price-to earnings (P/E) ratio of about 31.1 times last year's earnings and an implied EV/EBITDA multiple of about 13.3 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 13.2% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 16.3%. Our model reflects a 5-year projected average operating margin of 14.3%, which is above Panera Bread's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 5.2% for the next 15 years and 3% in perpetuity. For Panera Bread, we use a 10.8% weighted average cost of capital to discount future free cash flows.
Margin of Safety Analysis
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $183 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRisk rating sets the margin of safety or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for Panera Bread. We think the firm is attractive below $146 per share (the green line), but quite expensive above $220 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate Panera Bread's fair value at this point in time to be about $183 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart compares the firm's current share price with the path of Panera Bread's expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $249 per share in Year 3 represents our existing fair value per share of $183 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
Pro Forma Financial Statements