Is This Doughnut Maker in Play?

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After being left for dead in 2008, Krispy Kreme Doughnuts (NYSE: KKD) has turned things around lately with rising revenues and profits, led by its international division.  Founded in 1937, the company has been around longer than any of its chief competitors, including McDonald’s (NYSE: MCD), Starbucks (NASDAQ: SBUX), and Dunkin' Donuts (NASDAQ: DNKN).  However, each of these competitors has amassed store counts significantly larger than Krispy Kreme, due to a variety of factors including expansive product offerings and greater efficiencies in their store operations.

One Hit Wonder

Krispy Kreme has always focused on doughnuts, which account for 90% of total sales, with each store offering up to 16 varieties of its secret, yeast-raised recipe.  The company’s marketing strategy includes its Doughnut Theater, a multi-sensory experience that allows customers to see the entire doughnut production line.  Strong sales and store openings that followed Krispy Kreme’s IPO in 2000 led management into a ill-advised acquisition binge using large quantities of debt.  Unfortunately, the subsequent decline in unit sales growth made it difficult for the company to meet its debt payments, requiring the closure of 240 stores between 2004 and 2009. 

At this point, Krispy Kreme seems to have worked through its problems and has restructured its domestic store base, which ended 2011 with roughly the same number of stores as it had in 2008.  Part of its new corporate strategy has been to centralize production and shrink its average store size, thereby allowing the company to place stores in lower volume areas.  In its latest fiscal year, Krispy Kreme reported revenues and operating income of $403.2 million and $25.6 million, increases of 11.4% and 68.7%, respectively, versus the prior year.  The company’s margins benefited from a 14% price increase that it instituted in March 2011, as well as a greater percentage of sales from the high-margin wholesale channel.  While the company has been decreasing its convenience store reseller base, due to competition from private label products, an increase in the number of grocer resellers led to an 11.4% increase in wholesale sales.

In FY2012, Krispy Kreme has continued  to deliver solid results, with increases in revenues and operating income of 5.5% and 44.4%, respectively, compared to the prior year period.  The company benefited from a 4.7% increase in comparable store sales and continued growth in its international base of stores.  Overseas markets have always been a source of strength for the company, with the segment accounting for 66% of its total store base.  In the domestic retail market, the company’s operating margins rose sharply as increased centralization of production has created greater efficiencies in the cost of manufacturing its products.  Over the next year, Krispy Kreme is even looking for growth in the U.S., with plans to open smaller shops in its core Southeast U.S. market.

Going It Alone

Can Krispy Kreme make it as a standalone entity, given its larger competitors and consumers’ desire for greater choices?  Let’s look at the competitive landscape:

Golden Arches:  McDonald’s is a global power with 33,000 stores around the world and has been focused on increasing market share with its line of McCafe coffee beverages.  In its latest fiscal year, the company generated a 14.1% increase in operating income, with a 5.6% increase in global comparable store sales.  They will be hard to beat.

The Empire:  Starbucks is the world’s largest coffeehouse chain with 18,000 stores worldwide and enjoys consistent yearly increases in comparable store sales in the high single digits.  The company has convinced people to pay high prices for coffee beverages and has built a strong brand name in both retail and wholesale channels.  In its latest fiscal year, Starbucks reported increases in revenues and operating income of 13.7% and 15.6%, respectively, as it opened the most stores in the past three years.  They are formidable with CEO Howard Schultz at the helm.

Two For One:  Dunkin’ Donuts is the world’s leading baked goods and coffee chain with 16,800 locations around the world and a history that dates back to 1950.  The company also owns the Baskin-Robbins ice cream shop chain, which it has combined with its donut shops in over 1000 locations.  Due to an exclusive focus on the franchise model, Dunkin’ Donuts generates the highest operating margins in the industry and expects to eventually reach 15,000 U.S. stores.  This baker wants to win.

Looking Ahead

With roughly 700 stores, Krispy Kreme probably needs to join forces with a larger entity capable of delivering meaningful economies of scale in its operations.  While it has improved its coffee line with 3 new blends in 2012, beverages still only account for 10% of total sales.  The company’s strong brand name and popularity, though, could prove valuable for a strategic acquirer looking to gain a stronger foothold in the breakfast business.  Joh. A Benckiser bought both Peet’s Coffee and Caribou Coffee recently, and it could be a likely pursuer as its seeks to build its empire.  Until then, investors should put Krispy Kreme on their watchlist.

rghanley owns shares of Krispy Kreme Doughnuts. The Motley Fool recommends McDonald's and Starbucks. The Motley Fool owns shares of McDonald's and Starbucks. 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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