"And by the way, the bulk of the billions in Berkshire Hathaway has come from the better businesses. ... And most of the other people who've made a lot of money have done so in high-quality businesses." -- Charlie Munger
At Tier 1 Investments, a Motley Fool Real-Money Portfolio, I seek out and invest in elite businesses. These include companies with the most valuable brands, best management, superior products, and strongest competitive advantages. I call these businesses Tier 1 enterprises, and Panera Bread fits that description perfectly.
An aspirational brandbuilt on quality
One of the major growth stories over the next decade will be the trend of healthier eating. People are becoming more aware of what they put into their bodies. They aspire to eat better, and maybe even more importantly, they want their children to eat better. Few companies are as well positioned to benefit from this trend as Panera Bread.
Panera has built an aspirational brand that people trust. Customers are willing to pay a premium to dine at Panera because they know that the company uses only fresh, high-quality ingredients. Panera's bakery cafes serve delicious and highly rated soups, salads, and sandwiches, and they bake their bread fresh each night. But Panera is more than just a bakery cafe. The company has become a "third place" between work and home, along the lines of what Starbucks has accomplished, by offering up free Wi-Fi and a comfortable environment in which customers can linger as they eat, work, or simply sit back and relax. Panera explains it best:
We are bakers of bread. We are fresh from the oven. We are a symbol of warmth and welcome. We are a simple pleasure, honest and genuine. We are a life story told over dinner. We are a long lunch with an old friend. We are your weekday morning ritual. We are the kindest gesture of neighbors. We are home. We are family. We are friends.
Combine this ethos with Panera's award-winning customer service, and you begin to understand what separates Panera from its peers.
The numbers tell the story
Signs of Panera's competitive advantage -- based on its differentiation-by-quality approach and the experience-based nature of its business -- can be seen in its financials. The company has earned a 24% return on capital over the past 12 months, up from 12% in 2007, and that's while growing revenue by 15% annually over the past five years. Panera's management has managed this growth well and has funded the company's expansion mostly from cash flow from operations. That approach has allowed Panera to build a fortress-like balance sheet, with $290 million in cash and no debt. Even better, Panera's balance sheet should continue to strengthen as the company's strong cash flow generation -- more than $160 million in the last year -- adds more and more cash to its coffers.
It's also important to note that Panera operates in the highly fragmented and mostly mature restaurant industry, so future growth will come mostly by taking share from competitors. But while it's somewhat true that Panera competes with the likes of Chipotle and other quick casual restaurants, Co-CEO Ron Shaich doesn't see it that way. He believes that as long as consumers continue to choose Panera when it comes to soups, salads, and sandwiches, Panera will keep on winning. Panera's excellent revenue growth, strong cash flow generation, and high returns on capital give evidence that he's right.
Management "gets it"
Here at The Motley Fool, one of the highest compliments we can give a business's management team is that"they get it." I believe that Panera's executive team, led by co-founder Shaich, certainly meets that standard. They place a focus on the customer experience first and foremost. But management also treats employees like customers because they understand that happy employees go out of their way to make customers happy.
I also like it that management continues to invest in the business, even in difficult times. Through the 2008-2009 economic crisis, management continued to build new stores, and, impressively, not only increased overall revenue but also managed to achieve same-store growth. While many other restaurants were suffering, Panera was able to not only maintain its loyal customer base but also win new fans, probably because of management's focus on uncompromising quality.
And finally, while most of Panera's investments pertain to opening new bakery-cafes and upgrading existing locations, management has also demonstrated the ability to buy back Panera's stock at very attractive prices. While it's true that there weren't many bad times to buy back stock, since shares are up more than 400% in the past decade, management still deserves credit for pulling the trigger and returning cash to shareholders in a value-creating manner rather than wasting it on overly aggressive expansion initiatives. Their actions here boost my already high confidence in management's capital-allocation abilities.
Panera, despite its strengths, is not invulnerable to competition. Even fast-food eateries such as McDonald's have increased the amount of healthy foods offered in their restaurants to better compete with Panera's offerings. But while these threats are not to be overlooked, I believe that Panera's relentless focus on product quality has helped it earn a high level of trust among its customers, which should help shield it from more cost-focused competition. In addition, for many consumers, Panera's "third place" atmosphere gives it an edge over competitors built more around speed and convenience than around ambiance. Still, I will be watching closely for any signs that Panera's customers are beginning to defect to competitors, with metrics such as traffic and same-store sales growth helping in this regard.
Food cost inflation is another threat. If prices for commodities such as wheat and proteins rise at a faster rate than what Panera is able to pass on to its customers in the form of menu price increases, Panera's margins will suffer. But with gross margins rising fairly steadily over the past five years, Panera has demonstrated pricing power -- the ability to raise prices without drastically affecting demand for its products. But pricing power lasts only up to a certain point, and I will be monitoring gross margins vigilantly to see that Panera is able to keep its costs in check.
Panera is also not immune to global economic slowdowns. A pullback in consumer spending would hurt sales of the company's premium-priced food and beverages, as customers would probably cut back on their purchases or trade down to lower-cost competitors. But I've previously mentioned that Panera actually grew same-store sales during the last major recession, so while revenue growth will slow, it will probably remain positive. In addition, markets operate in cycles, and a downturn of this nature would ordinarily be followed by an economic recovery. So I'll probably view these types of pullbacks as opportunities to add to Tier 1's position in Panera, rather than a reason to sell.
As with quality food, I'm willing to pay a bit of a premium for quality businesses -- and Panera certainly fits the bill. But with the company trading at 24 times analysts' earnings estimates for 2013, and with analysts expecting 19% annualized growth over the next five years, I don't think we're paying that much of a premium for Panera. I believe Panera deserves a higher-than-average multiple because of the power of its brand, excellent leadership, and the long runway for growth. In fact, my valuation model returns a value of more than $185 per share, and with years of profitable store count growth ahead, Panera should provide healthy returns to shareholders over the next five years.
The Foolish bottom line
Panera is an elite business that is well positioned to profit from the healthier-eating megatrend. Today, investors have the opportunity to buy shares in this outstanding founder-led growth company and profit handsomely as it continues to execute its store count expansion strategy. And 24 hours after this article is published, I will be buying shares in the Tier 1 Real-Money Portfolio.
If you'd like more in-depth analysis on Panera, check out our special report on the casual-dining pioneer. Included are key areas that investors must watch, as well as opportunities and threats facing the company both today and in the long term. As a bonus, we'll keep you up to date on Panera for a full year, providing expert guidance and analysis as key news develops. Don't miss out on this invaluable investor's resource -- simply click here now to claim your copy today.
The article Panera Is Tier 1 originally appeared on Fool.com.
Joe Tenebrusomanages a Real-Money Portfolio for The Motley Fool and is an analyst on the Fool's Stock Advisor and Supernova premium service teams. You can connect with him on Twitter: @Tier1Investor. Joe has no position in any stocks mentioned.The Motley Fool recommends and owns shares of Berkshire Hathaway, Chipotle Mexican Grill, McDonald's, Panera Bread, and Starbucks. Try any of our Foolish newsletter services free for 30 days. We Fools don't 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.