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Analysis and valuation of Krispy Kreme

By

 

Danny Diab

 

5/8/2002

 

Finance 821 Investment and Portfolio Management

 

 

Krispy Kreme[1] doughnuts is a specialty retailer of branded premium quality doughnuts which are made throughout the day.  They operate 222 locations in 34 states and Canada.  They produce over 5 million doughnuts a day.  They have been rapidly expanding for the last few years.  Mainly through franchising which has accounted for the vast majority of growth in store numbers.  Krispy Kreme is a defensive company in the restaurant industry.  Most of their growth has come through a combination of franchising and their KKMD unit that sells the doughnut mixes and machines to make doughnuts, which all Krispy Kreme stores are required to purchase.  Krispy Kreme’s greatest asset is their image and brand name.  These are essential for attracting new customers and retaining old ones.  Krispy Kreme’s competition is limited to non-existent because they have been successful at differentiating themselves from all other doughnut retailers.

Revenues by Business Segment:

Year Ended

1999

2000

2001

Company Store Operations

80.30%

74.57%

71.06%

Franchise operations

1.79%

2.51%

3.14%

KKMD operations

17.91%

22.92%

25.80%

 

100.00%

100.00%

100.00%

 

            The overall economy is not a tremendously important factor in determining the success of Krispy Kreme.  Krispy Kreme is not affected as much by GDP and unemployment numbers as most businesses.  Just as the low to medium range restaurants are not hurt severely, and in some cases are helped, by a slowing or contracting economy.  Since Krispy Kreme is seen as separate from other doughnut sellers by most of its consumers they are not threatened by price wars and mass substitution, yet.  The success of Krispy Kreme will inevitably prompt many entrepreneurs, and existing restaurants, to introduce almost identical products.  The key is for Krispy Kreme to remain differentiated so that their name does not become a generic substitute for any hot doughnut.  Other trends such as the recurrence of health food manias and other consumer preference issues are also threats to Krispy Kreme’s potential.  Krispy Kreme is not exposed to serious interest rate risk as their financing is mostly internal.  They do have an unsecured revolving credit line at either Libor plus 100 basis points, or the bank’s prime rate minus 110 basis points, whichever rate is lower.  They are drawn on this line slightly but have repaid almost all of it through retained earnings.  The other exposure to interest rate risk is in the form of their short liquid investments which total over $30 million.  This is invested in government securities, commercial paper and corporate bonds.  Commodity risk is present to their KKMD unit which purchases flour, sugar and soybean oil, for the doughnut mixture.  Krispy Kreme does not use any form of hedging against interest rate or commodity risk.  This is to Krispy Kreme’s credit that it does not attempt to engage in speculation that it has no specialization in.

            Krispy Kreme is somewhere between birth phase and growth phase of their business.  They are beginning to reach the majority US population and are spreading to other countries such as Canada.  Krispy Kreme is exhibiting economies of scale as their revenues are rising at a faster rate than their expenses because of increased capital investment.  New technologies are also producing economies of scale, such as a new hot doughnut technology that finishes off partially cooked doughnuts in a few minutes.  They are working to improve the quality of their stores and their brand by remodeling, relocating, and/or rebuilding certain stores.  New sources of revenue and alterations to the business model are being introduced.  Krispy Kreme is beginning to increase its presence off premises through the sale of Krispy Kreme doughnuts, branded and unbranded, through retail outlets such as supermarkets and convenience stores.  An expanded beverage program is one other way in which Krispy Kreme will look to boost revenue.  Another new development has been the area developer form of franchising which they started in the mid 1990s whereby they grant a developer rights to franchise a region such as northern California if they pay 4.5% of their sales, plus 1% of their sales to a national advertising fund, and an additional $20,000 - $40,000 one time fee per store.  Their grand openings are used as a form of advertising by giving away free doughnuts to people waiting in line and turning them into major community events.  Revenue is gained in two ways from the new franchises, first of all it is garnered through the required 3% cut of all on premise sales and 1% of off premise sales, and secondly through the sale of doughnut making equipment and mixture through KKMD.  Advertising has been increasing at Krispy Kreme, over 220% from 2000 to 2001.  The addition of a new $35 million manufacturing/distribution facility in the Midwest will lower distribution costs is being financed through on-balance sheet debt instead of a synthetic lease, this will not affect their credit because of their extremely strong balance sheet.  Krispy Kreme is also adding a new small format doughnut and coffee shop. 

                        The financial condition[2] of Krispy Kreme is superior to that of its competitors but does have some areas that need improvement.  Krispy Kreme’s young management is showing that they want to be cautious and have employed an almost zero tolerance policy regarding debt.  Through their IPO and large secondary offering a year later, Krispy Kreme effectively paid off all of their long-term debt.  This seems to be a goal of management to keep the company liquid and flexible.  With the fast paced growth they have experienced debt is not yet needed to lever results.  Their times interest earned is far above the industry average, while their debt to equity ratio is far below. 

They have a higher ratio of accounts payable to sales than other businesses in the restaurant industry.  With debt seemingly under control, it seems the Krispy Kreme is holding too much cash, with a current ratio of almost 2, far above industry average.  Their days sales outstanding are much higher than the rest of the restaurant industry because they also sell their product off premises, and are owed money by convenience stores and supermarkets.  If the off premises sales start to expand it could increase their dependence on fixed assets; warehousing and distribution, which will lower their already industry low asset turnover ratios, and increase operating leverage.  Krispy Kreme’s superiority comes in the area of profitability, which is driven by above industry average profit margins, almost double the competition.  These profit margins are increasing and should continue to increase into the future as more of Krispy Kreme’s revenues are derived from the growth in franchising and therefore the KKMD division with its higher margins.  Return on equity is an area where Krispy Kreme trails the industry, especially the industry leaders.  This is because Krispy Kreme’s low asset turnover, combined with their lack of financial leverage.  It would be wise to increase the use of debt, where at the lower levels 10 – 30%, risk is not increased proportionally to the increase in financial results that will come about through:  1) Debt’s relative discount to equity 2) The tax subsidy that is afforded debt (writing off interest but not being able to write off the cost of equity) and 3) The leverage gained from using debt (increased equity multiplier).  Compliments will need to be found as doughnut sales flatten out and competition enters the market.  The same store sales from 2000 to 2001 increased only 13% so when the market begins to become saturated in the next few years growth will dry up.  This has prompted Krispy Kreme to become more aggressive in the area of beverages and reduce the number of company owned stores.  Some examples of companies that resemble the phenomenal growth and mass appeal of Krispy Kreme do exist, such as McDonald’s and more recently Starbucks in the 1990s.  Starbucks was growing consistently until the late 1990s when the market had become saturated and sales stagnated, Starbucks recovered and began selling products at retail outlets, and expanding internationally.  They also were successful in differentiating themselves, which lessened the impact of competition.  The growth expectations were as phenomenal for Starbucks as they are for Krispy Kreme, but when the expectations were not met investors saw Starbucks’ shares plummet 50% in a week during the late 1990s.  Krispy Kreme’s shares to date have risen faster in the 2 years since it has been public than the first 2 years Starbucks was public. 

 

 

 

 

 

 

 

 

            The most worrisome financial indicators for Krispy Kreme are their market value ratios.  On every account they are valued higher than their peers, and the market in general.  P/E, P/S, P/CF, P/B, etc., the list goes on.  Starbucks whose growth estimates are considered to be fairly close to those of Krispy Kreme over the next five years has a P/E, half that of Krispy Kreme.  The argument is that they will grow to justify their high price, but even their PEG ratio is much higher than other industry leaders.

                 

Krispy Kreme also has a much higher beta than the industry, requiring it to return substantially more to compensate for the added risk.  The stock of Krispy Kreme has had a remarkable run, but as other great companies with high expectations whose stock’s got ahead of themselves, the old statistical adage about reversion to a mean could come to spoil the party for Krispy Kreme investors.   Krispy Kreme has been fortunate to be in the right industry at the right time, as defensive and restaurant stocks have fared well over the last two years, but there are other factors weighing down on the stock:

                  

 

 

 

 

 

 

 

 

 

 

 

 

Since the collapse of Enron more attention has been paid to things not indicated on income statements and balance sheets, especially compensation packages for management.  The dilution that these options cause when exercised can hang over, and drag down the price of a company’s stock.  Not only does Krispy Kreme not cost account for these options, but in the area of the annual report where the options are discussed only the value of exercisable options is discussed, not taking into consideration the enormous quantity of options exercisable in the near future.  The value of the options currently exercisable[3] is over $32 million, while those options outstanding but not yet exercisable have a value in excess of $300 million.  That could weigh severely on the value of Krispy Kreme’s stock which has a market value of a little over $2 billion.  This is a cost to the shareholders of Krispy Kreme, the dilution to earnings that will occur, combined with the fact that the proceeds from the issuances of these new shares will not go to finance new initiatives that create capital appreciation, but will go to the managers that had a hand in bestowing the options on themselves. 

 

 


Valuation Analysis

 

Using an earnings multiplier Krispy Kreme’s stock would be worth:

P0 = Industry average P/E 25.55 x $.45 in diluted earnings = $11.50, which is incorrect because of the future growth potential of Krispy Kreme relative to the restaurant industry and their higher than average profit margins.  This price is too low.

 

Using Book Value:   $2.32 per share, which is a false measurement of the true value of Krispy Kreme’s business whose most valuable assets are its brand name and relationship with its customers. 

 

Using a Multi-Stage Growth Model[4]:

 

P0 = 5-yr growth at 27.33%[5] ke = 11.06% Long-Term Growth Rate = 8.00%            =(26.4*1.2733)/1.1106^1 + (33.616*1.2733)/1.1106^2 + (42.80*1.2733)/1.1106^3 + (54.50*1.2733)/1.1106^4 + (69.40*1.2733)/1.1106^5 + P2007 which is (95.44/(.1106 - .08))/1.1106^6 = 1185.43/54.1 million shares = $21.91 a share.

 

 

$21.91

 

Sell KKD

 

 

 

                                          



[1] Krispy Kreme Inc. Annual Report 2001

[2] Appendix A

[3] All the option values were figured using the black-scholes model, using 49.7% as volatility which was indicated in KKD annual report, 5.77% as Rf the rate on the 30-year.  Work shown Appendix B.

[4] See Appendix B

[5] Average of industry’s high low and medium range estimates.