Panera Bread (NASDAQ:PNRA.DL) recently reported first-quarter results and gave investors some key information during its subsequent conference call. Here are the takeaways most important to long-term shareholders.
Increased labor costs are taking a toll on margins
Minimum wage hikes across the country are putting upward pressure on labor costs in the food industry. In addition, Panera is adding workers as part of its "Panera 2.0" growth initiatives. CFO Mike Bufano touched on this during the earnings call:
Labor was again the most significant driver of the operating margin decline, delevering by 130 basis points. Two factors affected labor in the quarter. One, we saw structurally higher wage rates across the board due to continued pressure caused by increases in minimum wages. Two, the investment of additional labor hours necessitated by start-up costs related to a significant number of Panera 2.0 conversions and delivery hub openings in late Q4 and Q1.
Digital initiatives should drive operational efficiency
To help offset rising labor costs, Panera is investing heavily in converting its cafes to support digital ordering and payment, which is further denting short-term profitability. But CEO Ronald Shaich believes these investments will drive long-term sales and profit growth and also provide Panera with a competitive advantage over less digitally capable rivals:
As you know Panera 2.0 consists of two elements: first, it consists of digital access through mobile, web and [kiosk]; second, it consists of operational integrity ... Digital access creates a significantly better to-go and eat-in experience and it is the foundation for catering and delivery. It also materially impacts labor favorability over the long-term as there is no labor needed to input orders with digital. Furthermore, as digital utilization goes up, and surely it will, labor goes down. Indeed with high-performance, digital access [in place] Panera has far greater potential to both grow sales and to reduce labor for many years to come.
Catering can fuel incremental growth
Even as a current industry leader in catering, Panera has a huge runway for growth in this area. But it's a challenge for its cafes to meet that demand due to operational constraints. To solve that problem, Panera is building out a dedicated network of catering hubs to bolster its large-order delivery capabilities, as Shaich explains:
We likely have the largest market share in the country in large order delivery/catering. But it is still a very tiny slice of the potential market share we can obtain.
We know that this is a large business opportunity and we also know we cannot fulfill that opportunity out of the back of a $50,000 a week cafe. Finally, we knew that our cafes do a better job when they are focused on one master, retail, and when they do not have to make the difficult trade-offs of stealing people from the counter to serve the catering customer and vice versa.
We have come to learn that our catering business benefits from dedicated facilities that are set up and ready to handle the sales for multiple cafes. Because our hubs fill orders for multiple cafes and because they operate with much higher volumes, they're able to lower the sales volatility that makes a catering business so difficult to efficiently execute.
But Shaich notes that these investments will take time to bear fruit:
Let me share with you something else about our hub thesis. Our belief in delivery hubs is based on our experience with them. Several years ago we were forced by volume to open a number of hubs and in the case of these prototypical hubs, we found they generated a powerful IRR over time but produced short-term P&L pressure for the first year or two.
Adding a catering hub is like adding capacity onto a hotel that is already operating at full capacity -- it takes some time until that new capacity actually produces incremental profitability. Let me say this, I truly believe that investors are wise enough to know that these kinds of high IRR projects, in spite of the short-term pressures they generate, are a smart bet.
Delivery is another "powerful" growth opportunity
Management believes that delivery can also drive significant incremental growth at its cafes but recognizes the operational capabilities required to be successful. These include a digital ordering system with a fully customizable menu, an integrated production system, and a cost efficient driver network. Shaich stated that Panera believes it has everything but the driver network already in place:
We've come to believe that delivery offers us the potential to materially increase our sales volumes per cafe and to become a long-term driver of sales growth. In fact, I would call it a very powerful opportunity.
Further, we have come to learn salads and sandwiches, because they're generally not heated and because they travel particularly well in a vehicle, are a perfect product for delivery especially at lunch.
... We believe we have everything necessary to roll out delivery broadly with the exception of the driver network. That is why we are presently testing both internal and outsourced solutions to our driver network needs.
So where do we go with delivery in the future? We will expand our test to additional markets in 2015 and will make a judgment relative to a broader rollout in 2016. In any case, expect that when Panera does delivery, it will do it right.
Panera has a long track record of success
Panera has successfully navigated through several difficult transitions, as Shaich reminds us:
What sets Panera apart is we have done just these kinds of evolutions successfully before. We did it in the mid-1990s when we evolved Saint Louis Bread into Panera, establishing a vision for what would become the fast casual market ...We did it again in the late 1990s when we sold Au Bon Pain, the larger of the two companies, to focus all our energy on Panera ... And don't forget the years around the recession when we were contrarian and chose to invest in the customer experience despite the economic slowdown. Ultimately our comps improved significantly and we were beating other companies.
... The reality is we have a track record of seeing the future and executing initiatives that create significant long-term value. Here is the proof -- Panera's shares were up nearly 4,000% over the past 15 years as compared to 39% for the S&P 500. So I will tell you something I truly believe, we will do it yet again.
I believe winners tend to keep on winning, and I wouldn't bet against Ron Shaich leading Panera toward continued success in the years ahead.
Joe Tenebruso is portfolio manager of Tier 1 Investments, a Motley Fool Real-Money Portfolio. You can connect with him on Twitter @Tier1Investor. Joe has no position in any stocks mentioned. The Motley Fool recommends Panera Bread. The Motley Fool owns shares of Panera Bread. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.