Krispy Kremed

We're dueling for doughnuts here at Fool.com. While Bill Mann thinksKrispy Kreme is cooked, Rick Munarriz still has faith in the doughnut purveyor and offers up some suggestions for how to right this ship. Fools duel, and you win. Let us know what you think on the Krispy Kremediscussion board.

A tale of being too early: In October, I singled out Krispy Kreme (NYSE: KKD  ) as a company that investors ought to steer clear of.

That's October 2000, for those of you playing the home game. In the intervening three and a half years there had not been a single day in which Krispy Kreme's shares closed below the price that day, $22.13, adjusted for splits. Not until this past Friday, that is. In the interim, Krispy Kreme ran up as much as 140% higher than where I had labeled it "trouble." There were some dark days in that stretch, a great deal of crying and consoling myself with hot glazeds. But in the last few weeks, the wheels have come off of Krispy Kreme's stock, so we're back where we were in October 2000, share price-wise.

There are three ways I can play this particular article.

(A) I could break into a funky chicken dance and repeat the words "I told you so" 500 times until the end of the column. Not particularly appealing, since I don't think the drop in stock price is much cause for celebration, and let's face it, an investment selection that has now turned in a compounded annual return over 41 months of 0.05% is about as exciting as watching the furnace run.

(B) We could review what I said at the time, and see if these elements have changed, or if they still continue to dog the company. I like this a little better -- some review and analysis with the benefit of hindsight. We'll throw some of this in.

And (C), we can make a quick and dirty assessment of what went wrong and whether Krispy Kreme offers any kind of opportunity today. I like this best -- less navel gazing, more usefulness. We'll go C, with some B. No A.

One last thing: Krispy Kreme is one of David Gardner's selections in Motley Fool Stock Advisor. Please be aware that I am not David and do not speak for him, nor the other way around. David and I invest in entirely different manners, though we agree entirely on the importance of focusing first and last on the fact that Foolish investors focus not on stocks, but on businesses. There's no tribunal here at the Fool that determines what our official position is on individual stocks. We argue privately, we argue publicly, we each appreciate positions intelligently and honestly given. Just trying to fend off any "But David said..." confusion before it starts.

Hot Doughnuts Now
Let there be no doubt -- Krispy Kreme remains a hot franchise that has grown extremely rapidly -- as much as 45% per year in the last few years. I can't help, though, but look at some of the dots that Herb Greenberg put together on the company and wonder whether the management at Krispy Kreme wasn't sniffing its own underwear a little bit. Where I criticized the company in 2000, it was rapidly growing and debt-free. In the interim, the company has taken on substantial financing in order to speed its growth. I have no problem with companies utilizing leverage, but Krispy Kreme's not only used debt, but also issued equity and spent gobs of cash to keep the growth engine blazing. At some point investors should see a return on that incremental capital.

But as I noted back in 2000, net margins for Krispy Kreme are actually razor thin, and even though the company's doughnuts are incredible, much like Coca-Cola (NYSE: KO  ) , Pepsi (NYSE: PEP  ) , McDonald's (NYSE: MCD  ) , and any number other of low-price-point food and beverage companies, pricing power is still limited. Further, each additional Krispy Kreme location entailed a phenomenal level of capital expenditures, mainly for the production equipment.

This had the making of a Costco (Nasdaq: COST  ) style model, where maximizing turns of low-margin goods went first to recovering expended capital needed to build the location, then as fuel to fund further growth. Costco has only recently generated much in free cash flow, because it was plowing every penny of it has retained earnings back into the business. Krispy Kreme could have gone this route and done very, very well. But that's not as great of a story as phenomenal growth, and to hell with the economics. As we know, and as I noted in 2000, Krispy Kreme has very much been a story, and its buoyant stock price provided all the justification the company needed to continue apace. But meteoric growth doesn't continue forever, and such growth lacking economic veracity will almost always end very badly.

How to have every advantage and still blow it
If it sounds like I'm laying blame on the feet of Krispy Kreme's management, I am. I do not buy for a second that suddenly, after several years of meeting earnings targets, that in the first 13 weeks of this year the low-carb diet craze suddenly stood up and pummeled Krispy Kreme, catching management off guard.

While I don't doubt that low-carb diets are an ascendant trend, let's not beat around the bush. This is still a country full of fat, sedentary folks of the kind where bacon is actually an acceptable side dish for more bacon. This is an excuse, pure and simple. One of my investing heroes, Phillip Fisher, was explicit in his distrust of managements that were quick to take credit for everything good that happens to a company and blame the bad on circumstances outside their control. A surprising rise in the low-carb-diet fad killed your sales? Now? How convenient.

This is a company that has every advantage in the world -- its doughnuts are good enough to make grown men weep. But Krispy Kreme waited nearly 65 years before it took any tentative steps at all to expand outside of its base markets in the South. Then, as fast you could say, "You gonna eat that?" Krispy Kreme stores exploded onto the scene throughout the country. At the time the company filed to go public in February of 2000, it had 141 stores. Today it has well more than double that amount -- 357 stores, including ones in Australia, Mexico, Canada, and the U.K.

Instead of a sane Costco model or a more aggressiveStarbucks (Nasdaq: SBUX  ) one, we have a franchising morass that, if public filings of franchisee sales of Krispy Kreme stock are any indication, has some substantial flaws in it. Krispy Kreme relies heavily on what are called "area developers" to open new stores. Each time these developers open a store, they pay a fee to Krispy Kreme of $20,000 to $50,000, followed by a royalty stream thereafter of 4.5% to 6%.

This royalty percentage has increased since Krispy Kreme filed its registration statement, which could be a testament to the strength of the brand, but note also that Krispy Kreme provides debt and equity financing to some of its franchisees, taking ownership of from 25% to 75% of 17 different joint ventures with franchises. Now I have one question: Why would a company with a great product and an extraordinarily loyal customer base, which can simply sit back and count the cash from franchise royalties, take on the risk of financing joint ventures with some franchisees? And why did the company take on debt to do it?

The only reason I can come up with is to bring on growth as fast as possible. In every organism ever devised, there is such a thing as unsustainable growth. Adding risk through debt and supporting your franchise program suggests that Krispy Kreme is a case in point. If Krispy Kreme franchises are in such high demand, then there oughtn't be a need for support from the company. If you're going to create a center-supported franchise system, you might as well just open up stores fully owned by the company, a la Starbucks. It just points to things inside not being what they seem.

I've seen the short arguments that Krispy Kreme doughnuts are a "fad food." Hardly -- this is a 68-year-old company with a core product that has not appreciably changed in decades. In North Carolina, the local Krispy Kremes are landmarks, indelible parts of the community. It is this long-term loyalty that presents the company with the best opportunity to right itself -- if it isn't already too rotten on the inside. But the boffo shareholder returns that a Krispy Kreme promises aren't going to come to pass if management continues to pursue a strategy of growth at any cost.

We've seen that song before, a promising little company that grew too fast and blew away. It was called Boston Market. Now it's a sleepy little corner of the McDonald's empire, having been rescued from bankruptcy.

This is a promising company that has barely tapped its potential markets, but I see management's maltreatment of shareholder capital and I wonder whether they'll quit trying to be a growth stock and start being a company instead.

Next: Read Rick Munarriz's bullish take: Saving Krispy's Kreme.

Bill Mann owns shares of McDonald's and Costco. He appreciates reader email, but regrets that he cannot give individual advice. The Motley Fool is investors writing for investors.


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