We Expect Narrow-Moat Panera to Make Some Bread

With restaurant transaction trends continuing to outpace industry averages, we have greater confidence that "

The costs associated with these investments will weigh on profitability in 2016 and 2017. However, as comps improve and customer experience investments shift to franchisees, we believe Panera's longer-term margin opportunities will become more apparent to the market. Certainly, a competitive fast-casual restaurant landscape provides risks to our assumptions, but we believe transformation efforts will spur greater unit-level productivity (where Panera is already among industry leaders, with $2.5 million in average unit volumes) while bolstering operating leverage, positioning Panera to better compete with rivals.

We expect Panera to generate system sales of $5.2 billion in 2016, 12% of the $44 billion domestic fast-casual industry and more than half of the $10 billion domestic fast-casual bakery-cafe category. We expect fast-casual restaurants--which offer higher-quality ingredients than quick-service chains but lower average prices than casual dining restaurants--to grow around 9% annually during the next five years, owing to a compelling consumer value proposition and unit economics (lower real estate and labor costs than casual dining operators). This exceeds our low-single-digit growth forecast for the restaurant industry, implying market share gains for Panera. Based on acceptance of the brand and real estate availability, we believe Panera can add 1,200 new locations over the next 10 years, implying 3,200 locations by the end of 2025.

Our fair value estimate is $250 per share, which represents 32 times our 2017 EPS estimate, an enterprise value that is 13 times our 2017 EBITDA estimate, and a free cash flow yield of about 3%-4% after a reduction in the company's current investment cycle. While Panera's implied relative valuation statistics are ahead of industry averages, it is partly a byproduct of the company's current technology and customer experience investment cycle, and we expect comparative multiples to normalize as these investments taper down.

For 2016, our model is aligned with management guidance calling for 4.0%-5.0% same-store sales growth at company-owned locations, with 2.0 productivity efforts such as peak-hour throughput investments, higher-ticket signature items, meal upgrade programs, catering, and customer loyalty program engagement helping to offset slowing restaurant industry trends. We also expect investments behind these initiatives to taper during the back half of the year, but still result in a 30-basis-point decrease in operating margins for the full year to around 8.7%, slightly better than management's forecast of 50-100 basis points of contraction). Our model also calls for an 8% increase in EPS from 2015 adjusted EPS of $6.21, at the high end of management's guidance for 7%-8% growth (or adjusted EPS of $6.67-$6.72).

Looking beyond 2016, our model assumes Panera will open 90-120 units per year (representing mid-single-digit annual unit growth) and deliver mid-single-digit comps even after factoring in increased fast-casual competition, resulting in roughly 7% average annual revenue growth. These assumptions imply there will be 3,150 Panera locations by 2025. Over the same time horizon, we expect restaurant-level margins to grow to the low 20s (compared with 16.3% in 2015) with operating margins expanding to around 16%, owing to higher-margin menu additions, increased fixed-cost leverage, a vertically integrated supply chain, and incremental contribution from the catering, delivery, and consumer packaged goods businesses. Even with a potentially slower consumer environment heading into next year, we believe the company will be positioned to resume double-digit earnings per share growth in 2017 (compared with our forecast for 8% growth in 2016), with our model calling for almost 20% average annual growth (including share repurchases) for 2017-20.

Nonexistent customer switching costs, intense industry competition, and low barriers to entry make it inherently challenging for restaurant operators to establish an economic moat. However, we believe Panera has developed a narrow moat, which we attribute to a strong brand intangible asset, upscale and convenient restaurant environments, continuous menu innovations that accommodate consumers' evolving views about healthy eating, meaningful technology upgrades to ease the ordering process and streamline restaurant operations, and nascent inroads into delivery/catering and consumer packaged goods.

We've been impressed by the early success of Panera's 2.0 initiatives--which utilize mobile technology as a tool to enhance the customer experience--and believe this approach could serve as a blueprint for what a modern limited-service restaurant concept should look like. Panera 2.0 also includes the rollout of mobile ordering (eat-in and to-go) and payment capabilities across the entire system by the end of 2016. We also believe increased mobile technology use has natural marketing synergies with Panera's current loyalty program, which encompasses more than 24 million members and accounts for roughly half of transactions (putting it among industry leaders with respect to loyalty-program usage, according to our estimates). In our view, these technology enhancements will help reinforce the company's brand intangible asset moat source.

We also view Panera as one of the best-positioned players to weather potential industry cyclicality for a number of reasons. First, we still believe Panera's recent market share gains more than justify the level of 2.0 technology/operating and delivery capacity investments. With these initiatives shifting to franchises in the next few years, it should drive system comps higher (and narrow the gap between franchise and company-owned locations) with reduced company expenses/capital investment, setting the stage for medium- to longer-term margin and ROIC improvement. Second, we share management's views about Panera customers being more affluent and engaged across multiple dayparts/channels, offering some insulation from cyclical pressures. Lastly, Panera's efforts to develop a more convenient restaurant experience, accommodate consumer preferences for better-for-you products, and connect with consumers outside its restaurants have had a palatable benefit on its brand positioning, reinforcing our narrow economic moat rating.