Panera’s 2Q results reflected positive transaction growth despite a 5.5% retail price increase and operating margins grew YOY for the first time in 11 quarters, partly due to the 5.5% price increase. Panera was successful in sustaining 1Q08’s positive transaction/mix while growing margins, which is typically an indication of a balanced use of price. In the first 27 days of 3Q, however, this balance has already fallen off as transactions are running down 2.4% with retail pricing up 6%. The company is facing huge commodity headwinds in 2H08 and looking out to 2009, due primarily to higher wheat costs and gas prices. Management has set an internal goal to increase margins by 150-200 bps in 2009 off of 2007 levels despite these rising costs, which makes pricing a necessary component of this growth.
The company raised prices by 2.5% in November 2007 and followed that with a 2.7% increase in March 2008. Panera implemented another price increase on its bagels in June and is targeting a 1% increase across the menu in September, resulting in average pricing of 6.5% in 3Q08 and 6% in 4Q08. And, management commented that testing of a new pricing initiative for 2Q09 will take place in 4Q08. Although management stated over and over again that its quarterly value surveys show that the brand’s value perception has not changed since November 2007 when the company became more aggressive with its pricing initiatives, these price increases are concerning as it relates to their eventual (or current as it relates to early 3Q08 performance) impact on traffic trends. Management guidance assumes 1.5% to 2.5% transaction/mix declines in both 3Q and 4Q. On a positive note, Panera’s new breakfast sandwich helped to drive incremental traffic in 2Q while driving higher gross profit per transaction.

The big question going forward continues to be centered on increasing costs. Management has become more proactive in locking in its commodity requirements and is now purchasing its primary commodities six months ahead for a six month timeframe. This allows management to more effectively manage cost volatility. Panera has locked in 95% of its wheat requirements for 1H09 at a favorable price relative to 1H08 levels ($10 per bushel versus an average of $15) and expects to contract its 2H09 costs in 4Q08. Despite this YOY favorability in wheat costs, management is currently forecasting 5%-6% commodity inflation in FY09 with gas prices representing the biggest risk and unknown. It is this commodity risk combined with continuing concerns about the economy which led management to state that relative to the street’s current 2009 EPS growth projections of up 17%-21%, those expectations for growth “greater than 20% are not prudent at this time.”