Time To Short This High-Flying Restaurant Stock

In college, I had an eccentric statistics professor who was fond of a quote by the famous American poet Henry Wadsworth Longfellow: “Into each life some rain must fall.” My professor repeated this often, especially when passing out test scores.

Were he alive today, he’d probably have the same thing to say about any number of once-amazing growth companies that finally hit a wall. One such example is the well-known fast-casual cafĂ© and bakery chain Panera Bread Co. (Nasdaq: PNRA).

Panera was virtually unstoppable for years, adding hundreds of locations, posting superior growth in comparable-store sales (“comps”) and delivering very impressive profits. From the end of 2007 through May 2013, the firm’s stock shot up 429%.

But it hasn’t been the same since.

After topping out at about $193 a share, Panera encountered heavy turbulence. Two years and a couple gut-wrenching rollercoaster rides later, the stock sits about 4% short of its all-time high.

So what happened?

For one thing, top line growth has slowed. After rocketing 25% annually from 2007 through 2013, sales growth sharply decelerated to the current 6%-to-7% pace. Profits declined about 3% last year and further drops are a distinct possibility this year.

A key factor behind the slowdown is weakening comps. A few years ago, same store sales rose at a 7% pace. That rate has now fallen to less than 3%. Panera attributes this to demand outstripping capacity at some locations, leading to long lines, slower service and, in turn, lost sales. In other words, Panera is so popular, it can’t keep up.

#-ad_banner-#I’m not buying that, though. Fast-casual competitor Chipotle Mexican Grill, Inc. (NYSE: CMG) usually has long lines, too, even during what are typically off-peak hours. Yet the company’s comps rose by more than 10% in the latest quarter and have historically been exceptionally strong.

For Panera, I suspect the issue is a true loss of traction with customers. One sign of this is increasing difficulty of attracting business to newer locations, as gauged by average weekly sales. For locations opened in 2013 or later, average weekly sales are typically lower than for locations established before 2013, analysts report.

Moreover, Panera didn’t substantially hike menu prices in 2014, opting instead to absorb most of the higher food costs that plagued the restaurant industry throughout the year. This suggests Panera doesn’t believe it has a strong enough grip on customers to permit price increases — unlike Chipotle, which hiked prices across the board last spring, but still had a banner year.

A crucial intangible that’s surely at play here: customer service.

Whereas Chipotle is simple and efficient, Panera’s menu and order fulfillment system are more complex, leading to longer wait times and higher rates of inaccurately filled orders. Dining areas are often tightly packed and can be difficult to navigate with a full tray of food.

To improve efficiency and accuracy, the company recently rolled out a highly publicized technology-based initiative called Panera 2.0. Among the program’s features are mobile and online ordering with a separate pickup area for takeout orders; iPad kiosks for placing orders onsite; increased staffing during peak hours; staff dedicated specifically to checking order accuracy; and a table-service option.

Panera 2.0 naturally comes at a cost — $125,000 per location, or about $230 million to upgrade approximately 1,850 existing locations. Management concedes this will adversely affect financial results, which explains why profits may drop this year. The consensus among analysts is for profits to fall about 4% to $6.25 a share this year.

Wall Street is responding to early progress on Panera 2.0 (and management’s recent announcement about an acceleration of share buybacks) with a burst of optimism, driving up Panera’s stock by double digits during the past few weeks. However, the initial enthusiasm is apt to fade once the Street realizes Panera probably won’t meet unrealistic expectations regarding major performance improvements by the end of the year.

With just a handful of locations converted to Panera 2.0 and only about 400 full conversions expected this year, Panera is a very good bet to disappoint during the next few quarters. It’s easy to imagine a sharp drop in the company’s stock each time it comes up short. That’s an inherent risk for any stock trading for a lofty 30 times projected (2015) earnings.

It’s also easy to imagine such selloffs becoming progressively worse as investor patience wears thin and many realize that Panera’s revamp could take up a few years to fully implement.

Risks To Consider: Many analysts and long-term investors may be assuming Panera 2.0 will deliver the desired performance boost. Although the initiative should have a positive effect, Panera’s business model will still be fairly complex and may remain error prone or fail to adequately speed up service.

Action To Take –> Panera is at a turning point, where it can re-establish itself as a top fast-casual dining destination and high-growth company or keep losing ground to a growing list of hungry competitors. I think the latter outcome is more likely because Panera 2.0 doesn’t do enough to address the customer service issues underlying the poor performance of the past few years.

Thus, Panera is no longer the excellent buy-and-hold investment it once was. However, as near-term results will probably disappoint, the stock does present a promising short opportunity and has already garnered substantial short interest, which now represents 11% of the trading float.

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