Description

Overview

·         We initiated a short position in Panera Bread Company (PNRA) following Q2 results. While the stock has come in over the last few weeks, we still think it could present a 20%+ downside opportunity over the next year. We’ll leave it to readers to trade it how they want, but we think our average price of $215 presents compelling risk/reward.

·         The bull case remains a “show me” story. The bar is high for management to show that Panera 2.0 and other investments resulting in depressed EPS (and explaining the expensive, “under-earning” P/E) will finally pay off, after being able to conveniently kick the can on earnings growth for the last two years.

·         While we generally dislike shorting businesses that are intentionally tanking margins via investment, we think there is little room for error in Street numbers and the future benefits from PNRA’s investments are understood well now. PNRA’s valuation is expensive even assuming bull case numbers. If our view on PNRA’s future growth structurally decelerating is correct, we believe PNRA could experience significant multiple compression.

·         Our price target of $165 assumes an equal weighting between our base case of 25.0x FY ‘17E EPS of $7.45 and 20.0x FY ‘18E EPS of $7.08. We calculate upside risk of $239, based on bull case Street FY ‘17E EPS ($7.95) and assuming P/E re-rates to 30.0x. This implies 2.1x risk/reward on the short side at our recommended entry point.

Business

·         Most readers know what PNRA is, so we’ll just stick to the facts that are most relevant to the thesis.

·         The restaurant concept is “better for you” fast-casual with a focused menu of seasonal soups, salads, and sandwiches. Like peers, PNRA also relies on LTOs, but the focus is more on providing relatively healthy meals for individuals and groups (catering is a new growth area) at reasonable prices. We estimate individual average check (ex-group/catering orders) to be a little north of $10.

·         2,007 total units; 905 company-owned (45%), 1,102 franchised (55%). This is pro forma for a refranchising initiative of 90 stores over the last 18 months. 87% of revenue is from company stores, 5.5% is from franchise royalties and fees, and the remainder is from selling fresh dough and other ingredients to franchisees from company commissaries. Over 65% of operating profit is from company restaurants, 25% is from franchise fees, and the remainder is fresh dough sales and unallocated G&A.

·         Management spent over two years making heavy investments in “Panera 2.0”, a comprehensive e-commerce and store-level operational improvement initiative, to refresh and modernize the store base. This has been the prevailing subject matter of the rambling hour-long prepared remarks portion of earnings calls. There is some helpful guidance from the company in the Q4 ’15 press release (the last time 2.0 was discussed in detail) on how to think about the components of unit economics, so we won’t regurgitate that here.

·         Stores post-2.0 conversion are expected to deliver 20%+ four-wall ROIC, though to date, management basically states the sample size is not large enough to be statistically significant. As of Q2, 522 stores were converted, and by the end of Q3, over 50% of company stores will have been converted in the past four quarters. Only 43 franchised stores have adopted 2.0, but this number will grow to 100 by year-end.

·         Virtually all of PNRA’s retail presence is in the US (very minimal footprint in Ontario, Canada, but no meaningful CAD exposure).

·         CEO Ron Shaich co-founded PNRA as well as founding rival concept Au Bon Pain. Insider ownership is not a significant risk or consideration in our short thesis.

·         PNRA first took on financial leverage in 2014 to authorize a share buyback program. Management continues to repurchase shares opportunistically today to support the stock.

Growth Algorithm

·         The historical growth algo was “broken” due to PNRA’s growth investments, so below is our best crack at how management plans to bridge to the long-term double-digit EPS growth target over the next few years:

o                   - Unit growth LSD-MSD % y/y (mix of new openings has shifted towards franchised stores)

o                   - SSS MSD % y/y (post-growth initiatives)

o                   - Revenue growth HSD % y/y

o                   - EBIT margin expansion (slow but steady given labor pressures, ongoing G&A, higher D&A from investments)

o                   - Share buybacks LSD % y/y

o                   - EPS growth DD % y/y

Key Thesis Points

·         With over 2,000 units system-wide and the owned/franchised mix now optimized at 45%/55%, PNRA is transitioning from a multi-year growth story to a mature business. Slower EPS growth is a structural reality not reflected by Street estimates, which will catalyze negative revisions and multiple compression.

·         Management has run out of near-term levers for earnings upside through unsustainable comp growth (price increases and mix), refranchising, and financial engineering. Panera 2.0 hasn’t significantly impacted reported numbers yet, and our research suggests that it is not likely to anytime soon to the extent that bulls believe. PNRA is taking 2.5% retail price increases to offset labor inflation and has seen mix grow more significantly in recent quarters due to more profitable catering orders growing faster. Traffic has not significantly accelerated, despite this being key to the bull case on 2.0.

·         PNRA has been reporting better than expected EBIT margins over the last several quarters (still shrinking y/y, but at the better end of management’s guided range). However, the reason for this is largely from refranchising 90 stores that were at lower profitability than the company average. Again, this is not sustainable and also not driven by the operational improvements implied by 2.0 conversions.

·         Newer initiatives like at-home food delivery and CPG are not likely to move the needle on EPS growth but are being priced into the stock with virtual certainty. Bulls’ view on the delivery opportunity is unrealistic. Delivery is viewed as having high incremental margins given sunk investments in 2.0 and catering with minimal new labor requirements. However, we believe for delivery to make economic sense in the majority of markets, management will either have to increase the planned delivery fee ($3.25) or spend significantly on marketing, both of which will have adverse impacts. Management under-estimates the scale they need to build for profitability in most markets, particularly as they are determined to create the capability in-house rather than use 3P drivers, in order for this to move the needle on EPS growth. Bulls also assume a blue-sky TAM expansion (getting to pizza delivery penetration over time) while neglecting competition/substitutes offering similar menu items with greater consumer appeal/value (Blue Apron, etc.).

·         The gap between company and franchise comps is currently wide; bulls point to this as evidence that 2.0 (rolled out to company stores first) is working, and franchisee adoption starting in H2 ’16 will start closing the gap and help drive EPS growth. In reality, our research speaking to franchisees, who are just beginning to adopt 2.0, indicates that rolling out technology into structurally less profitable markets (this is why these stores were refranchised in the first place) won’t have the same impact as in early adopter company-owned markets. Any lift to numbers will come at a slower pace over a longer period of time.

·         G&A investments will be ongoing in addition to the usual headaches for restaurants’ P&L (labor, food costs, etc.), which are not likely to abate, resulting in the Street modeling too much operating leverage despite just modest comp acceleration. This is a key component to bull case 20% y/y EPS growth in FY ’17E, which we believe is way too aggressive.

·         Valuation is expensive on every metric, even if you believe bull case numbers, and sentiment has notably improved in the last year. Expectations are high. Many shorts covered, as they were too early and got caught in a wave of positive revisions on a beat-and-raise to comp guide following Q1. With tougher traffic compares in H2 ’16, a miss or guide below on any key line item will disappoint longs.

·         Management is sloppy (guidance history presents compelling evidence) and not afraid to cut guide; in fact, they complain that the sell-side has been too aggressive with numbers.

Bull Case / Debates

·         PNRA screens poorly due to high P/E on depressed EPS given a heavy investment cycle.

·         Panera 2.0 is going to finally work now, as there is an “onset period” of 3-4 quarters between converting stores and when the comp uplift and margin benefits show up in numbers. H2 ’16 will see a large number of conversions from H2 LY drive a lift to comps and four-wall margins.

·         Food delivery is going to add the next leg of comp growth and margin improvement.

·         PNRA’s store base has been rationalized through refranchising. The gap between franchised and owned comps will close once franchisees roll out 2.0 starting in H2 ’16.

·         On top of all this, management does share repurchases to support the stock. They might also initiate a dividend.

Why Now?

·         PNRA is lapping tough y/y traffic comparisons within its reported comps in H2. Even assuming mix and price lifts continue, traffic will have to drive the upside. Though H2 is supposed to see a lift from recent 2.0 conversions, this is well understood by the buy-side.

·         Street numbers for FY ‘17E EPS look too high. PNRA is expected to give updated thoughts into how recent 2.0 conversions are performing with a critical mass of stores in the base on the Q3 call, likely with preliminary commentary regarding expected performance into next year.

Valuation

Note: Consensus refers to Barclays model.

·         We used the Barclays model as a read on what bulls are modeling (analyst has a $240 PT and it is his “Top Pick” in the space, close to what we see absolute upside as at $239).

·         There are a lot of moving parts to our assumptions, but we are clearly below these estimates for next year on EPS, which is the metric that matters most.

·         We are slightly ahead on comps, but we think our numbers are closer to where the buy-side is. Our unit growth assumptions are largely in-line with the Street.

·         We think G&A will have to continue growing significantly to support management’s various initiatives.

·         Our model gives PNRA credit for being able to re-up their buyback authorization. We model $200mm annually in outflows from the buyback in FY '17E and FY '18E, running down PNRA’s cash balance to < $100mm over the next two years and shrinking share count by > 2% y/y.

·         Management has guided “double-digit EPS growth” for next year, and bulls are clearly thinking this is a return to 20% growth (not done since FY ’12 on a smaller earnings base). If PNRA prints our EPS, the multiple should compress. Looking at other restaurants as comps, we don’t think PNRA should get > 20.0x on EPS (taking into account franchised/owned mix, differentiation of concept, LT unit growth potential, etc.), and that is on an EPS number two years out. Our downside case assumes a haircut to EPS in both years of 5% to our forecast.

·         If we’re wrong, we think P/E goes to 30.0x; on bulls’ numbers, that would be close to a $240 stock, in-line with Barclays.

 Risks

·         2.0 actually causes a massive comp acceleration in H2, basically rendering the crux of our short thesis useless. We don’t subscribe to third-party data, but those with access tell us the data that tracks comps in Q3 so far looks sub-par, which is part of the reason why the stock has been weak over the last several sessions.

·         PNRA could decide to continue refranchising aggressively. Management has indicated the refranchising plan is done, but they remain open if approached by franchisees, so driving franchise mix higher and making the biz more asset-light could help keep multiples and sentiment elevated.

·         PNRA initiates a regular dividend and/or takes on more leverage and buys back more stock. Based on valuation to other restaurants with less than 100% franchised unit mix, we think multiples already give management credit for being capital allocators. If PNRA whiffs or guides below Street, paying a dividend isn’t going to help much in the near term.

·         We don’t think PNRA gets acquired (rich multiples for financial buyers, no real strategic fit, and we don’t think Shaich is motivated to sell).

Catalyst

Misses and/or guiding below Street on quarterly earnings.

Negative industry SSS data.