What My Dad, and Peter Lynch, Taught Me About Panera

I've been fascinated with Peter Lynch's "power of common knowledge" concept ever since I first read One Up on Wall Street. It's the  promise that we can use our own personal experiences to gain a competitive edge in the market.

"Buying what we know" makes complex things, simpler. Nearly ten years ago, something my Dad taught me about what he "knew," restaurants, has me feeling optimistic about Panera's future today.

Yep, even after a bad quarter.

Dissecting Panera's "bad" quarter
I'll get to the conversation I had with my Dad in a moment but, before we ponder the opportunity in Panera, let's recap Panera's "bad" quarter. 

Panera's stock has slumped over the past month, since reporting disappointing second-quarter results, and it now trades about 20% below its 52 week high. In the quarter Panera did show strong sales growth, with same store sales rising at 3.7%, and it also reported a whopping 16% growth in earnings. Some other good news is that the company plans to open 115 to 125 stores this year, and earnings growth is expected to top 18%, annually. 

So why did the stock drop 5% on these seemingly good results? What made these good results "bad?" In short, it was expectations.

The company guided down for the third and fourth quarter. While Panera is still expected to grow in double digits this year, it guided down for the full year as well. Much of the reasoning is due to the fact that Panera is simply growing too fast. That's not the worst thing in the world, but even management has admitted to "bottlenecks" in both staffing and operations during peak hours.

The company now expects to earn between $6.75 and $6.85 per share.This is well below the previous analyst consensus and, these short-term issues, have lead to some analyst downgrades and uncertainty surrounding the stock.

With the stock stuck in neutral, over what may be short-term fears, it may be a good buying opportunity. But that only makes sense if Panera can continue to replicate its previous smashing success, in its new stores.

What my Dad "knew" about the restaurant business
About ten years ago, I sat with my Dad for lunch at the first Panera in our area. 

"This is how to make money," he said, gazing somewhere in the vicinity of the cash registers or bread. 

"Selling sandwiches?" I asked.

"No, these guys, whoever owns this place. They have the right idea. Their food doesn't go bad, their menu is small, their prices are high, and they don't have any expensive equipment or a ton of employees." He explained.

My Dad probably didn't realize it at the time but he had just made a profound case for investing in Panera. He was, in essence, proving Peter Lynch right. You see, my Dad wasn't an investor; he owned restaurants all his life. He knew all of the pitfalls that put most restaurants out of business, such as high labor costs, expensive equipment, and rotting inventory. Somehow, by simply observing their kitchen area and workers, he knew that Panera was wonderfully equipped to manage these common pitfalls.

I often wish I had the foresight to have used his insight and purchased shares of Panera early. However, despite Panera's rapid growth, their wonderful business model still exists today.

Panera's business model: A side by side comparison
Panera's winning business model comes down to one thing: costs. They charge a relatively high price for their food, while avoiding high costs.

Their restaurants exist somewhere in between the high end and low-end markets. Let's compare Panera with a high end restaurant that I love, Ruth's Hospitality (RUTH +0.00%), as well as a fast food stock that I recently recommended, Yum! Brands (YUM +1.18%). 

Panera serves many menu items that use similar ingredients, which saves them on both upfront costs (they buy in bulk) and lost inventory. Their menu is quite limited--salads, soups, sandwiches--which is a huge advantage over restaurants like Ruth's. While Ruth's also has to pay high production costs in Chef's, equipment, and maintenance to produce their food, Panera does not. 

Yet, even with food production costs that are more similar to Yum!'s, Panera is able to charge an average of around $7.50 (at least in the Chicago market) for turkey and chicken sandwiches. Panera doesn't need to invest in quality via waiters and hosts, yet they have a reputation of being an extremely high quality establishment.

They have it made. They're able to charge relatively high prices for cheap food.

Don't think like the street
Wall Street, of course, doesn't typically look at restaurants this way. Even the average investor will probably look at things like "P/E ratios," and dividends first. Well, if you go by that you will see that Ruth's has a P/E of 21, Yum!'s is 23, and Panera's is 26. You'll also see that Ruth and Yum! each pay dividends, while Panera does not; but is that what you should be basing your investments on?

I'd recommend that investors think more like business owners.  If you owned a restaurant you're biggest concern would likely be costs and revenue; how much revenue are you bringing in, and how much are you keeping.

As you can see by the table below, that's where Panera's business model really shines.

*FY 2012

To be clear, I recently recommended Yum! and I love Ruth's steaks. I'm not trying to steer you away from either of those investments.

I'm simply wondering aloud if Panera can resume its rapid long-term growth, assuming its short-term "bottlenecks" are worked out. 

Panera is on the right side of healthy eating trends, and has grown sales in excess of 25% annually over the past half decade. The MyPanera loyalty program now has nearly 14 million members, and there is plenty of room to add stores both domestically and abroad. 

The hard part for Panera is not getting people in the door. The question is simply: will they continue to earn a high enough return on capital, with their new stores, to continue opening them at current levels of over 100 per year.

In my opinion, by thinking like a restaurant owner, you'd have to say that the answer is "yes." At least that's what my Dad would say, and I'd have to believe Mr. Lynch would agree.