Will Coffee and Doughnuts Mix for Krispy Kreme?

It was an embarrassing way to go -- Green Mountain Coffee Roasters (Nasdaq: GMCR  ) founder and Chairman Robert Stiller was forced to relinquish his position after selling off company shares to meet a margin call. At around the same time, Stiller also sold a big personal stake in Krispy Kreme Doughnuts (NYSE: KKD  ) . Typically, supply and demand dictates that a stock's price will fall significantly when a big chunk of shares is released to the market. But that didn't happen in this case.

Venti growth to go
Everybody wants to get into the coffee game these days. It's hard to ignore the fat margins and enduring popularity of specialty drinks, as any Starbucks (Nasdaq: SBUX  ) investor will attest. Grind a few cheap roasted beans, add hot water and milk, and voila! -- profits. It's understandable that players in the typically low-margin food and beverage sector would be seduced by that nice java aroma.

That's why mass-market comestible purveyors like McDonald's (NYSE: MCD  ) now feature lattes and cappuccinos on their menus and in their advertising. Espresso drinks are helping drive top and bottom lines. Revenue and net income at the Golden Arches grew impressively in the latest fiscal year, at a 12% and 11% clip, respectively. Fellow coffee brewer Dunkin' Brands (Nasdaq: DNKN  ) clocked a 9% gain in revenue and about the same for gross profit.

Starbucks saw its 2011 revenue increase 9% year on year while net income zoomed ahead by 30%.

And this all explains why Krispy Kreme plans to boost the coffee offerings at its stores and outlets. At the moment, a mere 4% of the company's sales come from the popular hot drink. The company wants to double that figure, and it would certainly like to drive its margins into the double-digit territory occupied by Starbucks, Dunkin' and Mickey D's. In recent quarters, Krispy Kreme's margins have see-sawed in the mid- to high single digits (once a single-time gain from the release of tax provisions is stripped out).

Not the strongest brew
Reaching deeper into the coffee urn is a shareholder-pleasing move. And now Green Mountain has no leverage on Krispy Kreme to be its top or perhaps only coffee supplier (Stiller's position in the company was around $50 million, or 12% of the current market cap). This was one possible reason Krispy Kreme shares traded up on the news on Stiller's divestment.

Green Mountain's landslide is another factor. There aren't too many good coffee plays on the market, and investors have been running away from the company. Ever since famed investor David Einhorn sounded the alarm bell about the company's overvaluation, its stock has fallen more or less consistently. It currently trades at $26.27, or a frighteningly steep 77% off its one-year high.

So there's a bit of a flight to quality now, but it's questionable whether Krispy Kreme is the ideal shelter. It will probably need more than good coffee to boost its results, since its ambition to double java sales -- even if perfectly realized -- would add only around $16 million annually to its top line. Full-year revenue stands at just over $400 million. A few extra drips aren't going to excite too many investors.

Saying "da" to doughnuts

What's more promising for Krispy Kreme is international expansion. The company has a weak footprint in foreign markets, so there's plenty of room for new outlets abroad. To that end, the firm just inked a deal with Russian restaurateur Arkady Novikov to franchise 40 doughnut shops over the next five years, all of which will be located in Moscow. This is a much higher number than the company boasts in many U.S. states.

International expansion is a smart strategy in the coffee and pastry game. Starbucks, for one, wouldn't be as mighty as it is without the global presence it enjoys. In fiscal 2011, nearly 25% of the company's revenue poured in from countries outside the United States. Before long, certain countries might become as flooded with the company's outlets as American cities -- at the moment, it boasts more than 2,700 outlets in Asia alone.

The Russian market is a good one, and, as far as Krispy Kreme is concerned, it's far from saturated. Fifteen Dunkin' Donuts locations currently dot the Russian capital, and four more will open in the immediate future. The average Eastern European typically has a much sweeter tooth and lower healthy-food consciousness than his or her American counterpart, so any kind of fresh pastry should sell robustly there.

So for Krispy Kreme, it'll probably be doughnuts on the Don rather than coffee in Chicago that will drive future growth. The market likes the company's new emphasis on java, but that product alone won't give such a big jolt to its results.

Speaking of growth abroad, we have the skinny on a handful of American companies set to grow rich selling their wares internationally. Find out which ones in our free report, "3 American Companies Set to Dominate the World."

Fool contributor Eric Volkman owns no stocks mentioned in the story above. The Motley Fool owns shares of Starbucks. Motley Fool newsletter services have recommended buying shares of Green Mountain Coffee Roasters, McDonald's, and Starbucks, writing covered calls on Starbucks, and creating a lurking gator position in Green Mountain Coffee Roasters. The Motley Fool has a disclosure policy. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.


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  • Report this Comment On May 11, 2012, at 1:49 PM, wcolasc wrote:

    Coffee is important for two reasons. First, the margins on coffee are huge. Second, coffee gets folks in the habit of visiting your store on a regular basis, something doughnuts alone cannot do.

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