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Prelude

Given Panera’s dual-class shareholder structure, the company might not be in the line of sight of an activist.  With that being said, we believe Chairman of the Board and Chief Executive Officer Ron Shaich should take a page or two from our playbook and go activist on his own company!

Two former restaurant CEOs turned activist that we admire are Doug Brooks of EAT and Linda Lang of JACK.  Both stocks are up approximately 201% and 461%, respectively, since these CEOs originally laid out (EAT in 2010; JACK in 2005) fundamental changes to their business models in order to enhance performance and drive shareholder returns.  While these CEOs had to make very difficult decisions at the time, the rewards have been vindicating.  Thanks to their strategic moves, Brinker and Jack in the Box are now two of the best run restaurant companies in the space today.

An Open Letter to the CEO of Panera Bread Company

Dear Mr. Shaich,

I believe that you have a significant opportunity to restructure your company and, in the process, make your shareholders a lot of money.  At the same time, you will solidify your place as being one of the greatest, and most respected, CEOs in the restaurant industry.

Change is inevitable.  In fact, since you first started Panera, consumer tastes, behavior, and technology have all changed drastically – rendering parts of the Panera model outdated.  It’s time to become an activist CEO and reinvent the company.  What I’m going to write probably won’t sit well with you, and you will be inclined to immediately dismiss it, but I ask that you think long and hard about the suggestions forthcoming.  Ultimately, I believe they will make Panera an even stronger company.

Panera is a fantastic company, but it has a distinct opportunity to become greater, bigger, and more profitable than ever before.  To be clear, the best way forward today is vastly different from the ways of the past.  Importantly, my thoughts are in line with your stated belief that Panera’s success is dependent on your ability to create “long-term concept differentiation.”  Consumer behavior and tastes are evolving, and the changes you are currently making to your food policy are just the beginning.

Along those same lines, the company must address the secular decline in per capita consumption of bread.  While Panera’s identity is rooted in handcrafted artisan bread, consumer attitudes about bread have changed since you first started the concept.  I don’t think it’s a stretch to say that you’re not getting credit from the consumer by owning all the assets associated with serving this artisan bread.  Does owning the bakery chain supply chain generate a strong return on assets?  I don’t know, but I doubt it.  This leads me to my first suggestion:

1. Sell off non-core assets

Panera currently produces and distributes fresh dough through a leased fleet of temperature controlled trucks owned and operated by the company.  According to the most recent filing, as of December, 30, 2014, you had 224 trucks leased.  In addition, as of the same date, you had 24 fresh dough facilities, 22 of which were company-owned, including one located in Ontario, Canada.  We suspect this asset may be particularly inefficient considering it only supports 15 bakery-cafes located within that market.

As you’ve previously stated, the “essence” of Panera begins with artisan bread: “Bread is our passion, soul, and expertise, and serves as the platform that makes our other entire food special.”  While this may be important, this line of thinking may not properly reflect pronounced changes in consumer behavior.  Specifically, consumers have been consuming less bread, as per capita consumption of this food has been declining since 2000.  More importantly, absolute sales of bread in your stores only make up five to seven percent of sales.

Panera is the last remaining, vertically integrated public restaurant company that we know of.  Companies have argued for years that vertical integration is a competitive advantage.  Of course, in some cases, this is merely corporate speak.  Every vertically integrated company needs to decide whether they are operating more, or less, efficiently than they could be.  Jack in the Box was the last restaurant company to do so, when it rightfully decided to sell off its non-core distribution business.  The stock is up approximately 265% since this time.

Frankly, I don’t think distributing tuna, cream cheese, and certain produce to substantially all of your company-owned and franchise-operated stores gives Panera any competitive advantage.

Moreover, it seems as though the ownership of your supply chain actually limits the company’s future growth opportunities and creates inefficiencies on the P&L.  You already use other independent distributors to distribute some of your “proprietary sweet goods” and other materials to bakery-cafes.  Why not sell off your non-core assets and use independent distributors to distribute all of your products?  You could than redeploy this excess capital back into the business or return it to shareholders.  This leads me to my second suggestion:

2. Slowdown the rollout of Panera 2.0 and begin molding a concept of the future

I sincerely appreciate the level of detail you provided in the 4Q14 earnings release regarding Panera 2.0.  However, I don’t believe you accomplished what you had intended to, because the inconsistency of the results led to a lot of confusion.  I also appreciate that Panera 2.0 is part of broader set of initiatives designed to make your restaurants more competitive, but there can be much more done to improve the efficiency of the box.  None of the initiatives laid out address improving pain points that exist in the back of house or eliminating menu items that are difficult to prepare and simply don’t have the customer sell through.  In addition, it may be time to rethink the part of the box that is dedicated to selling bread.  Should we be thinking about Panera 3.0?  The structural changes that are needed at the core concept lead me to my third suggestion:

3. Slow unit growth and cut capital spending

It’s not possible to focus the company and its resources on Panera 2.0, or Panera in general, when you are accelerating unit growth.  There are a significant amount of unnecessary “growth” resources in place at Panera at a time when the box is in need of a major transformation.  Is this sending shareholders the wrong message?  Given the size and scale of Panera 2.0, why aren’t all of the firm’s resources going into it?  It’s also difficult to maximize profitability when you are spending G&A on unnecessary resources, which leads to my fourth suggestion:

4. Cut excessive G&A spending

Looking at comparable companies, your G&A seems to be much higher than needed – but this should come as no surprise.  Today, Panera is a vertically integrated restaurant company that is growing units at an inefficient pace.  Both of these can be easily remediated by thinking differently about the business model.  Every major restaurant company that has faced similar issues in the past has decided to streamline its structure and improve the operations of its existing asset base.  Panera has not addressed these issues which, in part, play into my fifth suggestion:

5. Aggressively refranchise stores

Refranchising will immediately help eliminate some unnecessary G&A.  While the majority of players in the restaurant space have transitioned closer toward asset-light models, Panera has taken the opposite approach.  Over the last four years, the percentage of company-owned stores has increased from 42% to 49%.  I understand these acquisitions were accretive to earnings at the time, but you now have a bigger problem on your hands.  As you know, you are the one responsible for investing shareholder capital to fix them.  Currently, your franchisees only operate approximately 51% of Panera’s bakery-cafes.  Given that these franchisees are well-capitalized (35 franchise groups operating approximately 27 bakery-cafes each), selling stores probably won’t be a challenge.  Even if current franchisees are out of the question, Panera is a highly desirable concept which, given the amount of liquidity in the market place, makes it likely that there are a number of potential buyers available.

Lastly we will be publishing our detailed thoughts in the coming weeks.  We believe that changes to your current business model will significantly enhance the margins, returns and overall earnings power of the company.  We put the base line earnings power of the company between $8-10 per share and the implied stock price between $240-$300  

I hope that you will consider some of my suggestions.

Regards,

Howard Penney