In this episode of Industry Focus: Consumer Goods, Vincent Shen is joined by senior contributor Asit Sharma as they dive into the latest earnings calls from Target (TGT 1.92%) and Dr Pepper Snapple (DPS) to determine how investors should interpret some of the key comments from management regarding the future of their companies.

The team also discusses some of the context behind the Panera Bread (PNRA) acquisition rumors as they correctly singled out JAB Holdings as the likely buyer.

A full transcript follows the video.

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This video was recorded on April 4, 2017.

Vincent Shen: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. I'm your host, Vincent Shen, and it's Tuesday, April 4th. Joining me via Skype is Asit Sharma. Great to have you with us, Asit!

Asit Sharma: Thanks for having me! Great to be back.

Shen: Fools, we have a two-part show for you this fine day. We'll be looking at some quotes from the management teams at Target and Dr Pepper Snapple, a sniff test for investors and shareholders. But before we get to that, Asit, I really wanted to cover some of the news that broke yesterday. Bloomberg broke this story right around lunch time, the idea that Panera Bread may soon be a buyout candidate. If you look at the intraday trading from Monday, you can see the stock soar immediately following the Bloomberg report. Shares ultimately gained 8% in the day, and reached a new all-time closing high of about $283. As it turns out, that comes on top of the all-time high hit last Friday, just a few days ago, by which point the shares were already up 28% for the first quarter of 2017. Can you give us a lay of that land, and who some of the potential suitors may be that might pursue Panera Bread?

Sharma: Sure. Basically, Panera Bread is more of a slow-growth company in the recent past, but it's a very predictable cash cow. It's a bakery restaurant concept, as most of our listeners know, and has been overshadowed in recent years by the success of Chipotle, which has had its own stumbles. It has almost been seen as an also-ran, yet it's a very intriguing business. Panera Bread, last year, did about $2 billion in sales. They have operating cash flow predictably between $300 to $400 million each year. So, the question is, who would want to buy this company? Bloomberg reports that there's a putative deal value of $7 to $8 billion. That narrows the realm of suitors. The most likely one is JAB Holdings, which is a conglomerate in consumer goods. It's based in Luxembourg. They're well-known for some recent acquisitions, including Peet's Coffee, the Douwe Egberts brand, which is partly the old Mondelez coffee portfolio and D.E. Master Blenders, if any of our listeners remember those names. They've also acquired the Keurig Green Mountain business. For those of you who are coffee aficionados, they bought Stumptownhigh-end roaster, and Intelligentsia Coffee. So, JAB Holdings is probably the most likely suitor, but Dunkin' Brands has also been mentioned as having possible interest in this company. I think Dunkin' Brands is not as likely, but we'll get to that in a moment. But, this is the basic story that cropped up yesterday. Maybe we can talk a little bit about why a holding company like JAB would be interested in Panera Bread. I'll flip it back to you for your thoughts, Vince, then I have a couple of thoughts, as well, on why JAB might find this company attractive.

Shen: Sure thing, thank you, Asit. It's interesting to note that in addition to the names that you mentioned, and because at this point there are no official comments from any of these companies yet, some of these other names that have been floated out there if you read some of the coverage for this story, Starbucks has been mentioned, even Domino's Pizza has been mentioned, which I thought was interesting, McDonald's and Yum! Brands as well.

Overall, as Asit mentioned with the business here, Panera, 2,000 locations across the U.S. and Canada. About 45% of them are company operated. The way their segments for their business break down, they have their company-operated stores, and then 55% of them are franchise operations, so they collect the royalties and fees there, and then they also have a small part of a piece of their business being fresh dough and other product sales to those franchisees that they supply. The company-owned stores, not surprisingly, make up the largest share of revenue at about 87%. In terms of the performance that the company has seen and outlook, for shareholders of Panera, and the potential suitors, as you view this deal, the fact is, revenue growth has slowed pretty significantly from high-teen percentage levels just a few years ago to about mid-single digit levels the past three years. Something that has been a pretty significant concern is the fact that while the top line has continued to grow at those mid single-digit levels, net income has declined each of the past three years, and they've been really going through share buybacks, reducing their shares outstanding almost 30% since 2012, to juice their earnings per share growth. The way I see it, ultimately, you have a company here that's still out performing in an industry where chain restaurants have been struggling quite a bit. 

I guess, when it comes down to it, $6.42 billion market cap, you mentioned a potential deal size around $7 to $8 billion. Right now, where Panera trades, price to sales of 2.3 times, forward price to earnings of 36.7 times. Where the stock is trading now, it's definitely not going to be exactly a bargain deal for whoever ends up picking it up.

Sharma: Correct. And one of the interesting things about Panera is that, depending on what kind of buyer you are, it changes its complexion as an acquisition target. Let's go back and look at the basic concepts in acquisition finance. The strategic buyer versus the financial buyer. Panera Bread is a great target for a financial buyer, maybe not so great a target for a strategic buyer. A strategic buyer wants to combine its own assets for a strategic reason with a target, and then blow up both of the businesses combined. So, there's a strategic reason to take hold and increase revenues, because of some strength that the target has. Financial buyers are actually looking for a company that is more predictable, where it can make a few tweaks, or perhaps even something more than a tweak, increase that EBITDA, earnings before interest, taxes, depreciation, and amortization, and reap those rewards year after year.

JAB Holdings is basically a financial buyer. If you look at the companies that Vince and I mentioned, they're all very strong, stable businesses. Many of them are leaders in their niche. JAB Holdings hasn't come in and drastically changed those businesses. It has an enormous balance sheet, so this is a company it can acquire and add to that stable cash cow businesses, if I could mix a metaphor between the stable and the cash cow. If you look at companies like McDonald's, which has been mentioned, Starbucks, Dunkin' Donuts, none of these is a true strategic fit with Panera Bread. Panera is a different kind of company. It's fast-casual, part restaurant, part bakery. It has a little bit of the coffee focus, as Vince mentioned, but it's a hard company to grow at a fast rate. It's just has reached a stage of maturity where that will prove more difficult to whoever operates it. If your objective is to get a nice return, then you're probably looking at JAB as a potential buyer. Now, I could be totally wrong. But that's why we like to play the game. My money is on JAB Holdings. I think if this deal goes through, it would be very good for this privately held business.

Shen: Sure. That's a really good description of the two different kinds of buyers that might be going into this. The last thing I want to touch on before we move on, something that speaks to the outlook of the company being more stable with those 2,000-plus locations at this point through the U.S. and Canada, something that's really interesting that the company has done really well is with their digital penetration, which is about 25% in the company-owned stores.

Also, their loyalty program, which we've talked about on the show before, 25 million numbers, I think these members account for something like half of transactions that the restaurant sees, and something else that might be a bit of a growth driver for the company going forward is their delivery footprint, which is now available at 15% of locations. We've seen with companies like Domino's, for example, mentioned as a suitor, how powerful that could be as part of their business. The Panera 2.0 initiatives that were rolled out recently, basically, a lot of operating and technological enhancements to some of these stores, and efficiencies there, and something that I noticed in the Panera Bread across the street, a lot of kiosks or tablet ordering, those have been rolled out to about 70% of the company-owned restaurants. These ongoing strategic investments, I think, have contributed a bit to the weaker operating margins for the company. Then, you have rising labor costs as well. So, that's some of the headwinds that are faced, but at the same time, the company is forward-thinking with the investments they make. 

That's going to be tied, a little bit, to the next company we talk about, which is Target. The idea here overall is that 2016 was just not a good year for the company. Their sales decreased about 6%. Going forward, they are expecting declining comps. If you look at the earnings call, the transcript from the management team, you'll see that the various executives who speak, including the CEO, spent far less time talking about the specific numbers for the year than you would usually expect, a lot more time talking about how they're going to be seeing a lot of weakness, a lot of pressure on their margins, and on their operating numbers, but how this is, long-term, a forward-thinking look because they need to invest in the seismic change they talk about in the retail environment. With these next two companies we talk about, we want to do a bit of a sniff test, or, Asit, the way you put it was "fact or fluff." Can you set us up in terms of the quote you wanted to look at, and also the main question that we're looking at for the listeners and investors?

Sharma: For Target, you look at fact or fluff, they are in a tight business situation, almost every brick-and-mortar retailer has felt the impact of over the last year. Vince, when you and I had our year-end special, we talked about this at the very end of the show when we were looking at our predictive trends for 2016. We talked about the pressure that Amazon was going to put on companies like Kohl's and Target, and all of their siblings. This has come to pass. This conference call that you mentioned, where Target had owned up to that 6% decline in sales, was a really interesting call, as you mentioned, because management essentially said, "Hey, we're going to change our financial model, we're going to adjust to the future by taking a hit on our earnings. We're going to invest in our supply chain to move items quicker to our stores. We'll engage in a little delivery of furniture. We will introduce more private brands." I know when you and I were talking before the show, there is a private brand called Cat & Jack, which grew to be a $1 billion brand almost overnight within a year. If you think about $1 billion, it sounds like a lot of money, but Target's sales last year were $69.5 billion. It's going to need a lot of this type of onion springs sprouting out of the ground to make an impact on their profit and loss statement. 

To give you the fluff or fact quote, this is from their CFO Cathy Smith, she said on the call on the EBIT line, so, earnings before interest and taxes, on the earnings line, "This year, we are planning to generate about $1 billion less than last year. This reduction reflects investments in enhanced store service, the continued shift into digital, support to develop, launch and market new exclusive brands, gross margin investment to ensure we are competitively priced, and additional investments in existing stores." So, this idea of fact or fluff, I'm going to take the first stab at this and I'm going to say this is fluff. Here's my reason. One of the things that was repeated on that call was that Target is going to take gross margin investment. What that means is, the company is going to start competitively pricing so it doesn't lose more businesses. To me, that's always a little bit of a dangerous signal. I do acknowledge all these other initiatives that we've mentioned, including more penetration into digital channels. I think last year, Target sold about 14% more digital goods than it had in the prior two years. However, a short term what we call taking of price, where you lower your prices to compete, that short-term gambit by the company often becomes a long-term expectation on the part of the customer. This is my concern with Target. It doesn't solve their fundamental problem of, how do you compete with the likes of What do you think, Vince? Fact or fluff?

Shen: I'm torn. I agree that ultimately, with the results that were presented, and the way the stock traded afterwards, a big decline -- the stock, I will add, is down something like 30% so far in 2017. That might be slightly off, but they're definitely struggling, and they're definitely looking for ways to reinvigorate their business. Investors in this company have been on a roller coaster ride the past few years. You think about, I think it was 2014 when they exited their Canadian business and took a huge loss on that, 2015 things seemed to have stabilized, and now in 2016, 6% decline in sales. Now the outlook is for ongoing declines in their comparable sales. So, that volatility, that shift ... I can commend management, to an extent, for the fact that they're trying to take this longer-term outlook, they make these longer-term investments in their business and try to tell these Wall Street analysts on the call, "Listen, we need a little bit of time for these investments and these initiatives to pay off, to see that return on investment." But all in all, I think, with a more critical eye, I will have to agree with you, more fluff. But, presenting a more bullish view of this, or, a more positive view of this.

They address certain things that resonated with me personally. Here's another quote from that call, they said, "Put a guest in the store, they are looking for inspiration, they enjoy discovery, they enjoy shopping. But very often a visit to, it's far more transactional. One item at a time, logon, check out, as fast as possible, friction free." I think that reflects a lot of the challenges that these brick-and-mortar operations face, which is declining customer traffic. That's affected the other industry we've talked about today, which is restaurants, especially with chain restaurants. You see less traffic at malls and shopping centers, and that has hurt a lot of the restaurants that are located near them, as well. But ultimately, the expression "friction free" speaks to a lot of people, younger consumers especially, who want to be efficient with their time, and technology overall has generally made shopping this very informed, competitive process, where you can price check, you can compare, at any time and place, and then press a button for very fast, often free delivery to your doorstep.

Ultimately, the company is trying to think about what is going to get their shoppers out the door and into stores. They mentioned the importance of things like experiences, and how that can be addressed in two ways. You can either have a really wide breadth of offerings, like a Costco model, or the fact that Wal-Mart has expanded into groceries; or you have a convenience model where, even Amazon, the company that's putting a lot of pressure on Target, where they're opening locations for their pick up concepts. And now Target is pushing some of their smaller-store concepts. I think they have 30 of them in operation now. They've talked about doubling that base with another 30 stores this year, 40 more in 2018. Some of the things they've learned from this test location, I think it was in LA, they really want to expand the aesthetics of the store, update them, make them more of an attraction, more of a place that people want to go, to boost that traffic. So, on the more positive side, I hear things like that and I think that's the right move. But, again, some of the finer details when it comes down to how they're going to try and step up the business, especially, like you mentioned, the investments in the gross margin, what that means is basically, they're going to be discounting and trying to get into a price war, essentially, with other bigger retailers like Wal-Mart. And that's really not a place I think Target ultimately wants to be. Any last thoughts for Target before we move on?

Sharma: Briefly, I like going toward fact in this comparison, the great case that you've laid out, Vince. One thing that you said that I will grant is a method for Target to turn this more into fact than fluff, and that is that smaller store format. When it comes down to it, this future for brick-and-mortar retailers is about smaller spaces, so less fixed cost per square foot. When you have anchor stores and these very large 20,000 to 40,000 sq. ft. stores, you're competing against Amazon's and Wal-Mart's fixed costs, which are now in warehouses. That's where they are investing their dollars, in technology warehouses and distribution. By experimenting with these smaller stores, which are more experiential, I think Target might have a way to turn some of this fluff into fact. I think it's a great point that you make. I also do think their brand resonates more than other brands. I think they have an edge over Wal-Mart, and it is a brand that customers, if you give them something to come into the store for, they'll return. So, there are some positives here. Still say fluff, but there is at least a narrow path to getting back to fact for Target. We'll see what 2017 brings.

Shen: Absolutely. I think this is a company that both investors and consumers are rooting for. They want to have that reason to shop with Target, and it's just a matter of the company executing, regardless of what strategies they may be, with their online operations or their small store formats. We'll see.

Before we finish out here, for our next company, this is a beverage company, Dr Pepper Snapple. I think it gets neglected on the show a little bit. We usually talk about the big guys with Coca-Cola and Pepsi. But, Dr Pepper Snapple is in a similar situation as its bigger rivals in that it is, overall, dealing with this ongoing decline in carbonated soda consumption. Despite that, the company has done quite well for its investors. Let's get right into it. In terms of the fact of fluff quote and the dynamic there, what did you want to look at, Asit?

Sharma: Dr Pepper Snapple, last year, grew 2.5%. The year before, they grew 2.5%. Yet, the stock has returned 95% over the trailing last three years. That's versus about 50% for Pepsi and just 20% for Coca-Cola. So, you're right, we talk about the big guys, and we sometimes neglect this interesting company. Investors have been willing to pony up for Dr Pepper Snapple because it has a diversified portfolio. It has brands like Peñafiel -- I apologize to our listeners who speak Spanish -- that's the number one carbonated brand in Mexico. It has Snapple, it has Mott's Juices, to supplement Dr Pepper and some of these other sparkling brands of sodas that we're more familiar with. The question is, how do you get over this 2.5% growth hump? Recently, Dr Pepper Snapple spent $1.7 billion to purchase Bai Brands, which is an enhanced water product that features fresh fruit flavors. It's one of these holistic, sustainable brands that the millennials gravitate toward. This was sort of Dr Pepper Snapple's answer to Coca-Cola and Pepsi's recent acquisitions to broaden out their portfolios. 

Here's the quote. This is from, again, another CFO. This is CFO Marty Ellen, who said on the company's most recent quarterly conference call, "Coming off our solid 2016 performance, we enter 2017 with a lot of momentum, and we expect another solid year of business performance. We're expecting net sales growth before currency translation of about 5.5%, with 3% of this growth coming from our acquisition of Bai." Now, remember, I said the company has grown revenues by 2.5% the last two years. So, essentially, the whole rest of the business is going to remain flat this year, and they have the Bai acquisition effect that will give them the rest of the growth. My question is, next year, does that just become something that's lapped, and the company is again looking for growth? You have to know that Dr Pepper Snapple was originally the distributor for Bai Brands. So, they're only acquiring the revenue they didn't already have. I'm going to lean on the side of fact, because I think this is a big acquisition for Dr Pepper versus its $9 billion balance sheet, and I think it's an aggressive move into a category where it hasn't had a lot of presence. I'm a little skeptical on how it's going to grow this new company organically after the first year. But I say, all in all, this is a fact. You can bank on this quote. It's not a bad acquisition. What about you, Vince?

Shen: I generally feel similar. I think, in this industry, especially when you have the traditional carbonated soda product, as that demand declines, a lot of these newer categories claim growth, and the one that's really popular right now is some of these holistic waters, the flavored waters that have swept a lot of interest and popularity in the last few years. Ultimately, a lot of the bigger players will turn to these younger brands, these upstart companies and acquire them, and leverage, ultimately, their reach or their resources and marketing to grow them very quickly.

I think Dr Pepper Snapple has that interesting position in that it makes its distribution capabilities available to these allied partners. Bai was one of these allied partners. I think the company gets a pulse on the industry in this way. On the flip side, and you had a great article on this, Asit, the company isn't always able to take advantage of some of these allied partnerships that they have because sometimes the really popular and ultimately successful brands get acquired by their bigger rivals like Coca-Cola and Pepsi. Some of the names that come to mind that have gone on to become massive successes include Rockstar, Monster, and Vitamin Water. Overall, though, Bai is an example, it's kind of a first step that this company can take, in terms of the type of opportunities it has with some of these partners and how it seizes them, ultimately.

But a lot of the opportunity also lies in the fact that a solid 80% or 90% of the company's business remains very U.S.-focused. I think a lot of investors are curious to see how the company might expand its reach abroad as well. Mexico, for example, was a significant growth driver in the past year. That's just one example in terms of markets that lie ahead that the company could push, in terms of that global reach, that direction. But, yeah, leaning more on the fact side. But, I think something to definitely keep in mind is the fact that the company was already, as you mentioned, handling the distribution for Bai. The uptake there is a limited upside.

Sharma: Yeah. My last three thoughts on this: if you're an investor in DPS, Dr Pepper Snapple, you still have to watch those soft drinks. Like PepsiCo and Coca-Cola, Dr Pepper Snapple is investing in marketing to prop up those sales, so it's going to have a tie up with the probably going-to-be-a-blockbuster Wonder Woman movie this summer. Then, 7-Up is going to have a $2 billion impression campaign across social media and digital TV. So, it's also having to pile resources into marketing to prop up those brands while it finds ways to innovate both internally and through these acquisitions that we talk about. But, if you've been holding Dr Pepper Snapple, you know that steady as she goes has rewarded investors. I say the company should continue to perform very well, at least relative to its two peers that we mentioned, those huge beverage companies. Again, like the last one, we'll see what 2017 brings.

Shen: Yeah. One last point I would like to make for this company is the fact that, as the overall carbonated soda category shrinks, Dr Pepper Snapple has done a good job grabbing a little share, growing its share, in terms of the brands under its umbrella, within that admittedly shrinking space. It's not going to go to zero. I think there will always be soda, and people drinking soda in this market. Also, that has seen growth in other markets as well. Again, what can the company do ultimately to expand its reach? I'll leave it there. Thank you, Asit, very much for joining us on the show.

Sharma: Thank you!

Shen: Fools, you can reach out to us and the rest of the Industry Focus crew via Twitter @MFIndustryFocus, or send any questions to [email protected]. People on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentions, so don't buy or sell anything based solely on what you hear during the program. Thanks for listening and Fool on!