Panera Bread: Report 2010

SUMMARY AND INVESTMENT CONCLUSION

I initiate coverage of Panera Bread (PNRA) with a Hold rating and $91 fair value estimate. In our view,
PNRA remains an attractive organic growth story, and I anticipate management will use free cash flow to
reaccelerate new restaurant openings in a number of underpenetrated markets, which in turn will support
top-line growth and multiple expansion. I think new initiatives will help PNRA sustain positive traffic in
the next few quarters. However, sales comparisons are becoming more difficult as the company laps
initiatives launched in 2H09, and although PNRA is protected on grain prices through mid-2011, the
recent rally in grain prices is likely to suppress margin growth beginning in 2H11. I thus contend there is
limited upside given the rally in the share price in recent weeks.

COMPANY ANALYSIS

Panera Bread Company is a small cap stock that sells on the NASDAQ with the ticker symbol of PNRA.
Panera Bread Company operates in the retail bakery-café segment of the restaurant industry in the
services sector. Under the control of CEO Ronald Shaich, Panera Bread Company functions under the
names of Panera Bread Company and St. Louis Bread Company. Panera’s stores are located mostly in
suburban areas near malls and other shopping centers. Panera Bread offers an assortment of breads, deli
sandwiches, salads, and pastries among other products.

Panera Bread Company began as Au Bon Pain Company in 1981 operating on the east coast. In 1993 Au
Bon Pain Company purchased St. Louis Bread Company, which was comprised of 20 bakery-cafes in the
St. Louis area. From the years 1993 to 1997, the bakery-cafe names changed to Panera Bread. In 1999,
Au Bon Pain Company sold all business units except for Panera and the company was renamed Panera
Bread Company. Since the companies restructuring Panera Bread Company has become one of Business
Iek’s “100 Hot Growth Companies.”

Panera Bread Company has recognized large scale growth in recent quarters and is now on pace for large
growth rates in the future. Panera currently has 429 franchise operated stores and 173 company-owned
bakery-cafes. Panera’s ability to increase sales of franchises has enabled Panera to grow rapidly. Panera
Bread Company is a small cap company with great growth potential as their name becomes more widely
known.

KEY VALUATION DRIVERS FOR PNRA

I think four principal factors will determine the share price for PNRA in the next 12 months:

 I contend sales initiatives will continue to be a top-line driver. I think PNRA will continue to
generate high-quality same-restaurant sales in the next several quarters because of (1) positive
customer traffic, with notable gains at breakfast and in off-peak periods; (2) increased purchases
of “Signature” items; and (3) the system-wide rollout of the “MyPanera” loyalty card program in
4Q10.
 In addition to same-restaurant sales, I expect accelerated new unit expansion to drive
topline growth. Given the company’s debt-free balance sheet and strong cash flow from both
existing operations and franchisees, I argue Panera is in a better position than its peers to expand
its geographic footprint as most markets—particularly on the West Coast and in Texas—remain
far short of penetration. I estimate accelerated new unit expansion would add approximately
$0.08 to our EPS estimate by 2012.
 Increased productivity at new restaurants and in the distribution network should provide
additional EPS upside, according to our model. I suggest management is experienced in
 Panera Bread: Report 2010
selecting sites that will produce average weekly sales of at least $40,000 level for existing sites,
which minimizes labor and other productivity-related expenses. I think this new unit expansion
can be supported by adding capacity at its existing fresh dough facilities rather than building out
new facilities, and estimate these savings equate to $0.03 of incremental EPS improvement in
2011 and again in 2012.
 However, grain prices have emerged as a concern in our view. The benchmark winter wheat
price reached nearly $7/bushel in August amid fears that a drought in Russia (the fourth largest
wheat producer in the world) prompted an export ban in that country and cut into global supplies.
Although the wheat price since has retreated to $5.80/bushel amid ample U.S. supplies, the price
is 45% above where it was one year ago. PNRA has locked in favorable grain pricing through at
least mid-2011, but I are concerned about higher prices cutting into margins beginning in 2H11,
given that wheat accounts for 20% of PNRA’s cost of goods sold.

COMPETITION

I expect Panera’s dominance in the bakery-café category to continue. The fast casual category overall
has performed well in recent years as recession-weary customers have been attracted to the category’s
higher food quality at a lower cost than traditional sit-down dining. Moreover, I think restaurants in the
fast casual category is perceived as being more healthy than traditional fast food chains at only a small
price premium to those restaurants. Since 2006, sales in the fast casual category have grown 30% to $23
billion. PNRA is far and away the market leader in the $4.5 billion bakery-café segment, generating more
than five times the annual system-wide sales (including franchisees) of its next largest competitor,
Einstein Noah Restaurant Group (BAGL, $11.07, Not Rated).

OPERATIONAL DRIVERS
I suggest PNRA’s same-restaurant sales will remain strongly positive thanks to multiple top-line
drivers. I perceive PNRA has an established reputation for overall value at breakfast and lunch, and since
1Q09, management has undertaken several initiatives to grow gross margins to reinforce its value
proposition.
I argue an improved menu mix is driving traffic while supporting margins. This is at the core of
PNRA’s category management program which aims to maintain traffic while increasing gross margin.
PNRA has stuck to a differentiated focus on freshness, and this freshness extends to the menu where new
items and limited-time offers (LTOs) introduced quarterly reinforce the concept’s focus on breads,
sandwiches, and salads.
PNRA also is increasing average transaction size through premium entrees and supplemental
purchases. The “You Pick Two” platform allows customers to select two items from a half-sandwich,
soup, or salad. Priced nationwide in the $6.49-$6.99 range, “You Pick Two” comprises about 40% of all
 Panera Bread: Report 2010
lunch and dinner sales according to our estimates, and building on the success of this platform, PNRA
allows customers to upgrade from the “Café” tier of lower-priced salads and sandwiches to higher-priced
“Signature” items for an additional charge.
I also think the mid-afternoon snack and breakfast dayparts are growth opportunities for PNRA.
Although smoothies are not a new product category for PNRA, I suggest sales this summer Ire boosted by
much warmer-than-expected weather in the eastern U.S., and I saw in our some of our checks that
customers substituted soft drinks with higher-priced smoothies. More importantly, I do not see any sign
that MCD, which launched smoothies nationwide in July—is taking away this business.
The MyPanera card is another lever for PNRA at its disposal. PNRA launched its “MyPanera”
loyalty card program nationwide earlier this month, and I suggest this program will sustain top-line
momentum for PNRA in 2011. Instead of a pure discount (e.g., buy five, get one free) used by peers,
PNRA’s loyalty program distributes “bounce-back” coupons provided at the register featuring a
discounted add-on item with a select purchase.
PNRA is maintaining pricing power—another important top-line driver—without losing
customers. Our model incorporates menu price increases of at least 2% in 2010 and 2011, which I think
will provide support for margin growth.
I still expect significant top-line growth to come from new units through at least 2015.
Management has pared back on new unit development in the past few years—I project a net increase of
81 net new units system-wide in 2010, down from more than 100 per years in the early to mid-2000s—as
it has concentrated on developing the highest potential ROIC sites.
The company’s franchise development model mitigates operating risk. As PNRA is beginning to
accelerate new unit growth, I suggest management will focus on the West Coast and Texas for franchise
unit expansion. I think it makes sense to pursue a franchise model in these regions because (1) the cost of
developing new restaurants in these areas (including real estate) are above the $900,000 company average
and (2) operating costs in these areas are higher.
Keeping new unit productivity high. Average weekly sales in the class of units opened so far in 2010
(around $41,000 through 1H10) are above the $36,000-$38,000 range provided in management guidance
for the year and 4% above the pace of first-year units opened in 1H09.
PNRA’s balance sheet and cash flow are key positives. Aided by double-digit growth in net income, I
model free cash flow of $130 million (or $4.37 per share) in 2011 and $147 million (or $5.05 per share)
in 2012, up from $108 million (or $3.46 per share) in 2010, even as the company is ramping up new unit
expansion.
New unit development will be a key use of cash, and I would not rule out acquisitions. I think the
Panera concept remains underpenetrated nationwide, and thus suggest management will use cash to
accelerate new unit growth to 7% in 2011 and 2012, up from 4% in 2009.
However, I think the market is taking into account more aggressive share buyback activity. I
contend management used recent weakness in the share price to buy back shares, which I think is one
reason why PNRA’s share price has increased 26% since the August 16 low of $72.83 (compared with a
7% rise for all restaurant stocks).

FIANACIAL MODEL
 Panera Bread: Report 2010
VALUATION

I do not see much upside to our $91 target price in the near term, which I think already reflects
accelerated comp growth, margin expansion, and a rebound in new unit development. The 67%
jump in PNRA’s share price in the past year reflects an incremental improvement in the consumer
outlook, which has been manifested through aggressive multiple expansion across the restaurant sector
and amenable commodity prices, particularly for grains.
Panera Bread is a relatively new player in the restaurant industry. It was not until 1999 that they made an
impact in the industry and investors began to realize their potential. Panera’s historical data shows their
turnaround in growth and the impact it has had on their stock price. Panera Bread’s stock price has
steadily been increasing at an impressive rate. The assumptions used in the free cash flow analysis are
based on historical statistics as well as growth projections in the future. Panera Bread still has much room
to expand in the restaurant industry and has shown much indication that they plan to do just that. Panera
Bread does not currently pay dividends, so the free cash flow analysis and market comparable analysis are
the best measurements to find Panera Bread’s intrinsic value.

INVESTMENT RECOMMENDATION

I feel that Panera Bread Company is a sound company with real growth potential. At this time though, I
do not feel that Panera Bread is a wise investment for the SIMM portfolio because the FCFF and FCFE
value the stock just above its current selling price. The small return of about $2 is not worth the risk
involved in buying the stock. I feel that this stock would be a buy at the price of $33.50, which would
give us a return on investment of approximately 20%. At the onset of this valuation process Panera Bread
was selling at $35.50, but due to a strong month of November for stocks, Panera Bread’s price rose to
$39.99. I would recommend this stock as a buy if the price dips to a level that would result in a return of
around 20%. If this does occur depending on the reasons for this drop in price, I feel that Panera Bread
would be a strong buy for our portfolio.

On average, professional analysts have recommended investors to hold or buy Panera Bread stocks. Most
analysts such as JP Morgan believe that Panera Bread’s proper value is $42.00. This re-emphasizes our
valuation of Panera Bread’s stock price at $41.93. Analysts are encouraged with Panera Bread’s recent
growth rates. Panera Bread is 95% owned by institutions meaning that the larger institutional investors
like Panera Bread as an investment.
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Panera Bread: Report 2010
Panera Bread: Report 2010