Donut Wars: KK vs Dunkin
Jon is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
I am a man of simple pleasures. Always have been. My favorite childhood memory is the day my mom taught me what that "Hot Now" light means at Krispy Kreme Donuts (NYSE: KKD). The light means that the donut machine is on and it's time to get your butt inside. After going in and watching through the glass, my dad told my sister and I to pick out a donut. We did. We watched it go through the machine, into the grease, through the glaze waterfall, and into the employee's hand while my sister and I ecstatically claimed ownership of our respective donuts.
Today I'm what you call a donut snob. Not just any donut will do. Krispy Kremes are my undisputed favorite, and probably always will be (although, I do really like Dunkin Donuts (NASDAQ: DNKN) Boston creme...). However, fond childhood memories and a particular palette are not reasons to add a stock to your portfolio. They make good donuts, but are they a good investment?
Not a Get Rich Quick Scheme
I'm pretty sure if you wanted to get rich quick, you shouldn't open a donut shop. Seriously, donuts aren't exactly cheap to make. I can make Krispy Kreme imitation donuts at home for about $0.50 apiece. In their financial reports, they don't outline exactly what it costs them per donut in materials, but looking at the overall cost of goods sold will give us a better idea. Last fiscal year they had $403 million in sales. The costs of those goods were $354 million. Even though that statistic includes coffee, it's pretty clear to see that the margin is small. The problem is, they can't mark their donuts up much before people will stop buying them. Many people already feel like the donuts are overpriced.
A buddy and I went on a weekend camping trip a few years back. After canoeing through the swamp for a couple of days, we decided to celebrate the good times with a Krispy Kreme breakfast of champions. I walked up to the counter and asked the donut lady for a dozen donuts. Her eyes lit up as she said "But they're so expensive! I don't see how anyone can afford to eat here!" True story and sums it up: donuts, regardless of costs to make, can't be marked up to realize a better margin. Even the donut lady agrees with me. There's relatively small profit, which is why both Dunkin and KK have had problems in the not-so-distant past getting out of the red.
Dunkin' has put a lot of emphasis on branding themselves as something more than just a donut shop the last several years. Their coffee line has a faithful cult-like following. They have a regular menu now. Rachel Rae has been doing her part to get the word out. This shift from being "just a donut shop" is in hopes to get sales from higher profit margin items to boost net income.
Other food service companies have seen the need to expand their menu offerings. Both Starbucks (NASDAQ: SBUX) and Tim Horton's (NYSE: THI) have added actual meal items to their menus in recent years. Both Starbucks and Tim Horton's are known for coffee. But nowadays Starbucks serves salads and Tim Horton's has lasagna. They want to be known for more than just coffee. If you are only known for one thing, then people will only go to you for one reason. Give customers more reasons to walk through your door, and same store sales should go up. I think this may be a reason why both these companies are experiencing significant same store sales growth:
| Company | 2010 | 2011 | 2012* |
| Starbucks | 7% | 8% | 7% |
| Tim Horton's** | 4% | 6% | 6.6% |
*This data is incomplete
**United States same store growth
Dunkin' has Krispy Kreme beat when it comes to adapting the business. KK has not made a serious attempt at expanding the menu. They have delved a little bit into the coffee arena, and they mentioned a bigger drink selection at some point in the future, but the overall business plan is still just donuts. The first statement of their growth plan is: "we will continue to strengthen our core doughnut line through innovative limited time offerings..." Limited time donuts. Many companies attempt to increase sales by offering a limited time item. McDonald's sometimes offeres limited time items, like the McRib. But McDonald's doesn't bet the farm on the McRib; they are constantly looking for ways to adapt and improve what their business offers. The McCafe is a case in point. I think true "innovation" will be found in something other than donuts.
They've Turned The Ship Around
Surprisingly, even though they have doubled down on donuts, Krispy Kreme has been making money lately. As recent as fiscal 2010, Krispy Kreme came up with a huge year end loss. But the last couple years have been profitable. The most recent quarter was respectable, and light years better than profits just a couple years back. Nothing fundamentally has changed with the business; things are being managed better.
Where Growth is Coming From
On top of managing things better, Krispy Kreme is growing. They are growing in two main areas:
- Same Store Sales
They have really focused hard on getting their existing stores to increase their sales. They have seen 15 consecutive quarters of same store growth. That is nothing to ignore; that is fairly significant. That means that even if they hadn't opened another store, they still would have grown.
- International Growth
This prospect excites me. KK has been growing overseas the last couple of years (mainly in Mexico). Donuts are undoubtedly American. There are places in the world where people don't know what a donut even is. If you are ever in a foreign country and find yourself needing to explain what a donut is, just say that donuts are the round things that Homer Simpson eats. They'll then know what you are talking about.
Donuts overseas has potential. As a friend of mine from latin america put it: "we've seen them for years on movies and tv shows that come from the United States. We just didn't know what they were, but we'd love to try them." KK is hoping to have 75 new stores overseas this year. For perspective, they currently have 694 total stores. That would be over 10% total growth just overseas.
What They Could Do
There's nothing wrong with taking a play from the top competitor Dunkin' Donut's playbook. I would like to see Krispy Kreme look for revenue in more places than just donuts. Some things they could do:
- Take the coffee business more seriously
- Launch this mystery drink thing
- Get a full-blown menu
Doing any of these things could ignite some new streams of previously untapped revenue.
Conclusion
There are some things to like with Krispy Kreme's business. But things are just ok. I wouldn't say it's a screaming buy. I think it is currently a risky investment. But on the other hand, it wouldn't take much to trigger faster and more profitable growth. We just don't know if/when that will happen. What is the price on this risk? Just a 3.21 P/E ratio. Competitor Dunkin has a 54 P/E ratio.
Like I said, to me it's not a screaming buy, but with a P/E ratio that low, the price is already down to earth. In the meantime you can be sure I will continue to contribute to Krispy Kreme's top line growth (and my mid line growth) every time I see the "Hot Now" light on.
thequast has no positions in the stocks mentioned above. The Motley Fool owns shares of McDonald's and Starbucks. Motley Fool newsletter services recommend McDonald's, Starbucks, and Tim Hortons. 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.If you have questions about this post or the Fool’s blog network, click here for information.
