Panera: Crusty and Stale

My wife and I were sitting in our favorite booth at our local Panera (Nasdaq: PNRA  ) , where we go a few times a month to order soup and sandwiches and chat for a while.

"Have you thought about investing in Panera?" she asked. "We spend plenty of money here -- and so have these other people. Maybe it could be a good investment." Peter Lynch would be proud of the way she thinks.

"You know, the price has been coming down lately," I said as the buzzer called me to the pick-up counter. "I think it's time to take a quick peek at what's going on."

It's been a rough ... year?
That's actually a gentle description of Panera's price decline. Shares have actually been dropping faster than a yeast-deprived sourdough bread loaf. The stock is down 42% since its 52-week high last October. Unfortunately, it made another 52-week low Friday.

What's going on? Same-store sales have not been up to snuff recently, food and labor costs are rising, and margins have plunged faster than expected. My Sierra Turkey and French Onion soup always taste great, but the recent financial performance just isn't cutting the mustard.

I know it's not quite over, but should we chalk up 2007 as just a tough year, and look to the future? Not so fast. A peek back in time at the table below will reveal some interesting information.

FY Ended

FY Ended

FY Ended

FY Ended

TTM

 

12/27/03

12/25/04

12/27/05

12/26/06

3/27/07

Gross Margin

37%

36.7%

36.8%

35.3%

34.9%

Operating Margin

13.7%

12.9%

12.7%

11%

10.5%

Net Margin

8.4%

8.1%

8.1%

7.1%

6.7%

Data from Capital IQ.

Yes, you see it correctly. Margins have been declining steadily across the board. While sales growth has been kicking in harder than a Caffe Mocha with a Very Chocolate brownie, earnings growth has slowed to a crawl. Expanding sales doesn't help if those additional sales are less profitable.

For whatever reason, investors seem to overlook declining performance trends, as long as strong growth is on the way. Panera loves to show off its impressive sales growth in the titles of its pre-earnings releases, and even though management spoke about some cost-cutting initiatives, it peppered its most recent call with rosy talk of how sales would grow.

Peeling back the onion
Growing sales and declining profitability stinks. There's just no two ways about it. Investors should not be happy with that combination -- it's a waste of your capital.

Here are my calculations for returns on invested capital over the same time period we covered above:

FY Ended

FY Ended

FY Ended

FY Ended

 

12/27/03

12/25/04

12/27/05

12/26/06

ROIC

14.7%

13.2%

11.8%

10.8%

Capex

$45.8

$80.4

$82.1

$109.3

Capex from Capital IQ; ROIC from author's calculation.

If I were a shareholder, I'd be upset that Panera can't allocate capital well enough to generate the highest possible returns. The company's investment in new stores doesn't seem to be paying off; returns keep decreasing, even as capital investment rises. Sure, more assets are being added to the equation, but if newer stores were as productive as older stores, wouldn't those numbers remain constant, at the very least?

Panera isn't the only company I've criticized in the past. Late last year, after Red Robin's (Nasdaq: RRGB  ) price dropped, I took a deeper look and found that its ROIC was around 10%. That's not very attractive to me, but at least it's holding steady.

Compare this to what's happening at Chipotle (NYSE: CMG  ) . It's growing very quickly as well, but its operating margins continue to increase as it grows. As a result, its returns keep rising. That's why I thought it would be a great stock for 2007.

What's a Fool to do?
Running a restaurant is undoubtedly tough. Dining firms deal with fickle tastes -- I hear people say all the time that they can't stand Panera, and that's it's nothing special -- and lots of costs to manage. Typically, they command little pricing power, leaving them with a delicate balance between menu prices and customer traffic. Think of the endless choices available to hungry diners, from McDonald's (NYSE: MCD  ) to Darden Restaurants' (NYSE: DRI  ) Olive Garden, all the way up to Morton's (NYSE: MRT  ) .

So despite the great growth, I can't quite see Panera as a turnaround possibility. I get no indication that management will focus on increasing its returns. It's mainly focused on sales, and according to the latest proxy statement, it doesn't seem to have any incentive to create shareholder value and keep returns on invested capital high. As such, the only stock I'll be ordering is the one in my soup.

Chipotle is both a Hidden Gems and a Rule Breakers recommendation. Both of these market-beating newsletters can be ordered free for 30 days.

Retail editor David Meier's wife enjoys the Portobello Mushroom sandwich and many of Panera's hearty soups. David does not own shares in any of the companies mentioned. The Motley Fool's disclosure policy is always fresh.


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