This fast-casual restaurant chain reported a disastrous quarter. Management missed both profit and sales expectations and was forced to slash next year's guidance. Same store sales will decelerate to low-single digits while rising food prices will pressure margins. You might think I am describing the quarter Panera Bread (PNRA) just reported, but you would be wrong. Those were the results of Chipotle Mexican Grill (CMG) reported in the third quarter of 2012. The quarter sent CMG shares down from $290 to $243, a drop of 16%. In the past year, shares have more than doubled to $520 as management fixed some issues and sales soared. Those who sold CMG on one bad quarter at $250 aren't feeling too happy right now! I believe PNRA is in a similar position.
On Tuesday, Panera Bread reported a disappointing quarter, and the naysayers have come out in full force, suggesting the company faces inevitable decline and doom. I use the Chipotle anecdote to show that focusing on one data point is folly, and by doing so, investors can lose the forest through the trees. We can't just ignore bad results, but after any quarter (good or bad), it is always better to keep a level-head rather than act rashly and irrationally. I believe Panera still has strong growth prospects and will explain them here.
Excluding beneficial tax items, Panera reported earnings of $1.35, 9% better than last year. For the full year, PNRA will earn about $6.80, 15% annual growth. This growth is obviously decelerating from 20% in the first half to about 10% in the second half. More importantly, management, without issuing specific guidance, said earnings next year will fall short of their 15%-20% growth goal. I expect PNRA will see similar trends in 2014 as it has in the second half of 2013, if not a little softer. With that in mind, a reasonable expectation will be $7.30-$7.50 in EPS. At my midpoint, Panera is trading at a multiple of 20.7x.
The most troubling part of Panera's report is related to same store sales. In the quarter, sales increased by a slow 1.7%. Breaking down these sales further, the size of each check increased 2.7% while actual volume declined 1%. Foot-traffic actually fell in the quarter, which suggests at least a mild lack of interest. Now, the third quarter has been a weak one for all casual restaurants, which makes this drop a bit less concerning, but for a growth company, we rightly expect more from Panera. I was hoping for closer to 4% growth. While the company is still taking shares from restaurants like McDonald's (MCD), it was unable to attract new customers as easily as it had been. The only positive is that food prices have remained tame, and forecasted to stay that way in 2014, which should help margins remain relatively healthy.
The good news is that new stores are performing relatively well. When Panera opens a store, it targets $40,000-$42,000 in weekly sales, but new stores in the quarter were doing a healthy $44,779. Clearly, consumers are interested in the Panera brand. New stores would perform especially weak if there were brand or product problems because those customers have the least affinity towards the product, complicating what is causing the deceleration at its stores. The issue is in areas where Panera is already entrenched; it is struggling to grow its customer base in these places. With new customers flocking to stores, the product is not the problem, rather I believe the in-store experience is to blame.
Management is taking some of the blame for this, saying they have focused too much on controlling costs, perhaps at the expense of the customer experience and will be investing in improving processes in stores to rectify this problem.
For retailers and restaurants, problems can typically be boiled into two categories: product and service. Product issues are much more difficult to solve, and consumer tastes may simply grow incompatible with the restaurant brand. Much of Panera's problems can be boiled down to slow service, restaurants that could use a bit more investment, and so on. These problems can be solved more easily than a menu redo.
Consumers have also been showing preferences for simpler menus, something Panera does not have. Here, management announced a solution. It is restructuring its menu to make it easier for customers to navigate, by breaking options down by pricing tiers. This change in format should be released by the middle of 2014. At the same time, Panera will be incrementally increasing its advertising spend to head-off any problems with the Panera brand with disenfranchised customers. I also hope that with this new menu will come some new options.
Panera is firmly positioned in one of the best growth industries in America: fast casual. Fast-casual dining continues to take share from fast-food restaurants. Young consumers clearly prefer quality to price and are increasingly health-conscious. I believe PNRA and others in the group like CMG and Noodles (NDLS) are poised for years of strong growth. I do hope that with its newly-structured menu Panera considers changing some of its items. Many consumers are careful about their carbohydrate intake, and Panera has done a good job adding salads to its menu, but I believe by adding more low-carb items that would appeal more to men, Panera can be the premier lunch restaurant in the nation and reaccelerate sales growth.
For the long term, there is a major potential growth area for Panera: overseas. Currently, Panera operates in 44 states and Ontario but does no business in Europe or Asia. There are no immediate plans to expand overseas, but I believe there is a strong possibility PNRA expands internationally in the next 3-5 years, which could dramatically accelerate growth for long-term investors. Importantly, the international potential is not a reason for short-term investors to buy. However for investors with a 5-7 year time horizon, international expansion is viable.
Starbucks (SBUX) has built an exceptionally strong bakery business in China while Panera's business would be perfectly positioned for Western Europe. Within 10 years, I believe Panera could have 1,000 stores in Europe and 750 in Asia, which could generate an additional $10 in EPS. If PNRA were not to go international, I believe it can earn $20 in 10 years, suggesting a 6.5% annual return, assuming a terminal P/E of 15x. However, if it were to go international, the long run return would be 12-15%. At current prices, PNRA is basically providing a free option on its international potential.
Yes, Panera reported a weak quarter, but many great companies disappoint. The fact that new PNRA stores have been well-received suggests consumers still want its products, the issue lies with customer experience. With some investment in better processes and systems, Panera can rectify this issue within 2-3 quarters, just in time for an updated, easier to use menu. The doom in PNRA is overstated as consumers are trending towards its quality-focused product line, and when Panera decides to go international, earnings could explode. I do expect there to be some near-term turbulence, and there are probably downgrades in the offing. I would look to start a position at $145. With a stock buyback plan in place and earnings growth that I believe can return to 12% by 2015, PNRA would be an attractive long term play at that level.