What is stock analysis? Well, there are some that think it has everything to do with the dividend. There are others that only look at charts. There are others that think analyst estimate misses (notice how this is equivalent to companies' earnings beats) are a way to gauge the trajectory of a stock. And yet there are others who are lost in medieval times. We as investors need to move beyond these individual frameworks and start taking a holistic view. Let's take a look at what we mean as it relates to our analysis with Panera Bread (PNRA).
At Valuentum, 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 (click here for an in-depth presentation about our methodology), which ranks stocks on a scale from 1 to 10, with 10 being the best. Essentially, we're looking for firms that overlap investment methodologies, thereby revealing the greatest interest by investors.
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 Darden Restaurants (DRI), Starbucks (SBUX), and McDonald's (MCD). In the spirit of transparency, we show how the performance of our VBI has stacked up per underlying score:
- 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 is a national bakery-cafe concept with more than 1,600 company-owned and franchise operated bakery-cafe locations in more than 40 states, the District of Columbia, and Ontario, Canada.
- 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 8.5% in coming years, and the firm had no debt as of last quarter.
- The firm's share price performance has trailed that of the market during the past quarter. However, it is trading within our fair value estimate range, so we don't view such activity as alarming.
- 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.
Most Recent Quarterly Results
Panera's third-quarter report, released late October, showed relatively strong top-line and bottom-line expansion of 8% and 17%, respectively, but the real issue was with the firm's fourth-quarter outlook. For starters, the bakery-café cut its fourth-quarter comparable sales growth expectations for company-owned restaurants to the range of flat-to-up-2% versus 3-5% previously. Panera also cut its fourth-quarter earnings-per-share guidance to $1.91-$1.97 per share from $2.05-$2.11 previously on expected margin contraction of more than 100 basis points on a year-over-year basis. Though the new bottom-line outlook implies a 9%-13% increase over the comparable period in fiscal 2012, the ratcheting down of the target is a black-eye for management and a classic no-no for an above-market-multiple equity like Panera's. The firm's earnings growth appears to be decelerating, and we think expansion in the 9%-13% range is likely more achievable in 2014 than the low-end of its long-term growth target of 15%-20% (as it stated in the release). We're certainly watching developments at Panera closely.
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 grey 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. For more information on the differences between these two measures, please visit our website at Valuentum.com. 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.
The estimated fair value of $167 per share represents a price-to-earnings (P/E) ratio of about 28.4 times last year's earnings and an implied EV/EBITDA multiple of about 12.1 times last year's EBITDA. We estimate that its fair value range is $134 to $200 per share. The lower end of this range is now likely on the basis of its current fundamental trajectory. Our model reflects a compound annual revenue growth rate of 10.2% 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 14.4%, 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 $167 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 $134 per share (the green line), but quite expensive above $200 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 $167 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below 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 $227 per share in Year 3 represents our existing fair value per share of $167 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