Creamy Crisp or Undercooked?

Palwasha is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Editor's Note: The original article stated Krispy Kreme had zero cash and cash equilivents on the balance sheet. According to S&P's Capital IQ, KKD had $49.9 Million Cash and Cash Equilivents on hand on its Q3 balance sheet. This article has been corrected.

Krispy Kreme (NYSE: KKD) skyrocketed as management announced third quarter earnings. The company reported Q3 EPS of $0.12 that beat estimates by $0.04 and reported revenue of $107.1 million that beat estimates by $3 million. The stock is trading around its 260 week highest--that's right! It's five year highest.

Q3 Highlights

  • Total revenues saw an 8.5% increase to reach $107 million. 
  • Operating income rose 66% to $9 million
  • Adjusted EPS jumped 71% to $0.12, compared to $0.07 last year. 
  • Same-store sales rose 6.8% driven by higher traffic, without any pricing assistance.
  • All four of KKD's business segments, Wholesale, Domestic Franchise, International Franchise, and Supply Chain delivered positive top line revenue growth. 

The company so far has had 16 straight quarters of positive comparable store sales and all eyes are now on this donut maker. Could Krispy Kreme restore its lost glory of the early 2000s, when it traded in the 30s-40s range? Could it even break past the $10 barrier it hasn't been able to break in over five years? Could it beat rival Dunkin' Brands (NASDAQ: DNKN) at being a better investment? 

Positives

  • Brand Recognition: Krispy Kreme Doughnuts is more of a household name and is more widely recognized in the US than many other top tier doughnut makers like Tim Horton's
  • Customer-Centricism: KKD goes a step ahead of its peers in using relationship marketing to target its customers. The doughnut joint makes use of consumer research to identify what customers want and what they don't. A recent research at the company found that more consumers will buy Krispy Kreme doughnuts if provided with reasons and opportunities to do so. Therefore, to enhance doughnut experience, the company started making use of limited time doughnut and beverage offerings in accordance with customer demands. Special limited-time pumpkin doughnut offerings on Halloween and now Christmas-specific Santa doughnuts all generate customer interest and drive seasonal sales for the company. 
  • Investor-Centricism: KKD's CEO, Jim Morgan, acknowledges it and reassures shareholders that the management "will not manage this business for the short term." He believes in making decisions based upon what's best for the company and the shareholders in the long term.
  • Innovation: The company has brought in the new 110M production line to control costs. 110M is a revamped production system that has the capacity to meet higher consumer demand while occupying much less space in square footage than the older traditional production line. The company currently has four stores running the 110M and plans to open seven more in the next fiscal year that will utilize the same machinery. This new production line is very efficient in its consumption of raw materials and can help KKD achieve higher sales against lower investment--in other words, an improved sales-to-investment ratio.
  • Future Expansion: The company added 20 new Krispy Kreme stores in the latest quarter, taking the total to 731. Domestically, KKD has only 238 shops in the US and I see a lot of room for expansion here, especially when company-owned stores account for less than 15% of total stores and rest of the 85% are franchised, however, these franchises only bring in 8% of KKD's total revenues. Management plans to open 5-10 new company-owned shops next year and existing domestic franchisees are expected to open about 15 new locations in the US. The company has also announced future franchise development programs outside of the US in Singapore, India and Moscow. 
  • Cheap Fundamentals: Compared to its two close competitors, Dunkin' Brands and Starbucks (NASDAQ: SBUX), KKD is cheaply priced.
<table> <tbody> <tr> <td> </td> <td>Forward P/E</td> <td>P/B</td> <td>P/S</td> </tr> <tr> <td>KKD</td> <td>18.64</td> <td>2.58</td> <td> 1.48</td> </tr> <tr> <td>DNKN</td> <td>24.01</td> <td>10.27</td> <td> 4.92</td> </tr> <tr> <td>SBUX</td> <td>23.81</td> <td>7.46</td> <td> 2.85</td> </tr> </tbody> </table>
  • Attractive Financials:
<table> <tbody> <tr> <td> <p> </p> </td> <td> <p>Debt/Equity</p> </td> <td> ROA</td> <td>ROE</td> <td>Current Ratio</td> </tr> <tr> <td>KKD</td> <td> 0.21</td> <td> 52.91%</td> <td>74.21%</td> <td>2.71</td> </tr> <tr> <td>DNKN</td> <td> 5.98</td> <td> 2.71%</td> <td> 12.94%</td> <td>1.17</td> </tr> <tr> <td>SBUX</td> <td> 0.11</td> <td> 17.41%</td> <td> 27.9%</td> <td>1.90</td> </tr> </tbody> </table>

Negatives

  • Coffee: Most of you would generally agree with me that we don't buy coffee for doughnuts, we buy doughnuts for coffee. KKD rival Dunkin' Donuts, despite the fact that it has 'donut' in its name, advertises its lattes more than its doughnuts. Likewise, Starbucks, famous for its coffee, also offers a range of doughnuts and bagels for its customers to add to their coffee orders. KKD does offer a wide variety of coffee including cappuccino, latte, mocha and decaf, but its coffee remains less desirable compared to competitors. Management still needs to work on its coffee branding. 
  • Limited Scope: Sometimes when we don't feel like having something sugary in breakfast, a light sandwich with coffee is the way to go. The problem with Krispy Kreme is that they don't offer anything to complement with their beverages except doughnuts. On the contrary, Dunkin' Donuts offers a huge variety of breakfast and non-breakfast bakery sandwiches and oatmeal, in addition to sweet bakery items--doughnuts, muffins, bagels, and cookies. Likewise, Starbucks offers sandwiches and paninis for breakfast and an even wider variety of bakery items than Dunkin' Donuts, which includes scones, brownies, cakes, and breads. Limited scope narrows KKD's target market and limits its revenues. 
  • High Input Costs: KKD management expects fourth quarter costs for doughnut mixes, sugar, shortening, and packaging to be slightly higher than the third quarter. The company has been working on reducing consumption of key ingredients to overcome high costs without having to increase prices. The raw material-efficient 110M is one such measure to combat prices. The company has also purchased sugar for the next year at slightly higher than current prices, and shortening for half of next year requirements at slightly lower than present prices. However, nobody can say with full assurance how future prices will move.
  • High Systematic Risk: KKD has a risk factor (beta) of 1.56, above the market average of one. Dunkin' Donuts and Starbucks have much lower betas of 0.66 and 0.78, respectively, making KKD a much riskier investment of the three.

KKD management upped this year's EPS guidance to $0.44-$0.47 and $0.49-$0.55 for the next fiscal year. Analysts' consensus mean EPS estimate is $0.50 for the full year which gives the stock a fair price of $9.32.

For me, the negatives, being serious concerns, outweigh the positives. Invest wisely! 


PalwashaS has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. Motley Fool newsletter services recommend Krispy Kreme Doughnuts. Try any of our Foolish newsletter services free for 30 days. We Fools may not 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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