How to Make Krispy Kreme Doughnuts Beat Expectations

By now you've heard that Krispy Kreme's (KKD) FY 2014 third quarter earnings disappointed investors and analysts alike this past week. This disappointment came despite improved earnings for one of the faces of the $12 billion a year U.S. doughnut industry. In order for Krispy Kreme to beat expectations going forward, they will need to consider improving in some key areas while using the strengths of industry peers Dunkin Brands Group (DNKN) and Starbucks (SBUX 0.53%) for guidance.

By Unisouth (Own work), via Wikimedia Commons

Did Krispy Kreme deserve its 20% share price drop?
It was easy for Krispy Kreme to surprise the market to the upside when expectations were down. However, now they are at the point where they need to prove why they deserve their current 60+ P/E valuation. They need to show investors that this time around is not like 2000 or 2005 where growth stalled.

FY 2014 third quarter earnings showed revenue increased 6.7% to $114.2 million and same stores rose for the 20^th consecutive quarter. Net income also improved substantially to $6.8 million, up from $5.0 million, year-over-year. Even though the company also raised fourth quarter guidance, it is still below analysts' expectations.

What did the conference call reveal?
First, Krispy Kreme will start a new 40-oz ground coffee test program. This program will be initiated at select Sam's Club locations in the Southeast. When asked during the meeting about the program's large coffee size, CEO James H. Morgan admitted that the 40-oz bag is only appropriate for larger buyers. However, he may not have thought this out thoroughly.

Earnings did reveal that coffee sales were up 15%, year-over-year. However, Krispy Kreme coffee can only be bought at its retail locations or online through its website. A possibly more accurate program would be to run the test at existing Krispy Kreme retail stores first. Because retail stores are where the coffee is sold already, it might be easier to see how larger bags sell against current 12-oz bags with current Krispy Kreme customers.

Additionally, the results of the test program may be skewed. Better alternatives may be testing the bags at Sam's Club locations in different regions of the country. Whether the 40-oz bags sell well or not, the sample size of Sam's Club locations in the Southeastern portion of the United States may not be an ideal representation of the population as a whole.

A possible final option is selling them within grocery store chains. Because Krispy Kreme already has partnerships with many grocery franchises across the country for their doughnuts, it may be more appropriate to also sell coffee at these same locations.

The second bit of news from the call was the hinting of cannibalization among its franchise and company-owned stores. More specifically, CFO Douglas R. Muir suggested that cannibalization hit company comps for about 0.8% in the third quarter. This gives the impression that either there are too many Krispy Kreme locations already and the market is saturated or that management can't figure out how to strategically locate its stores

Possible improvement areas for Krispy Kreme's future...
Despite 250+ varieties of coffees across dozens of brands, a Krispy Kreme K-Cup still doesn't exist. Single-cup coffee has never been more popular but it seems that Krispy Kreme won't be following its peers Starbucks or Dunkin Brands anytime soon. A Krispy Kreme/Green Mountain Coffee Roasters partnership would be a win-win situation for both companies, and at the very least, would give Krispy Kreme a much larger distribution footprint and a share of the single-cup craze.

Krispy Kreme's mall presence, within traditional shopping malls or big box shopping centers, is lacking when compared to some of its industry peers and similar snack companies. It seems like Cinnabon and Auntie Anne's are in every mall as well as Starbucks. Malls are high traffic and visibility areas with relatively low upfront costs. Below is location count by company within US shopping malls only:

Credit: mallseeker.com

Because Krispy Kreme retail stores typically reveal how their doughnuts are made from start to finish, they may need to create an 'express' version of their stores similar to how other food chains that are located on smaller footprints and offer only takeout. These 'express' Krispy Kreme's could also be the answer to move into shopping center locations. Either way, the goal would be to increase their presence in locations otherwise occupied by their competitors.

Krispy Kreme's cannibalization troubles between its franchise and company-owned stores could be fixed by following Dunkin Brands and striving toward a nearly 100% franchised business model . Franchising would attract better talent since there is an incentive to succeed, reduce expansion capital needs by the company itself, and minimize growth risk. If Krispy Kreme really wants to reach its 400 domestic stores goal by January 2017, they need to consider franchising more.

Bottom line
Krispy Kreme had a solid 3^rd quarter, but now the doughnut shop is in the big leagues. This time they need to show the market that things are different and careless expansion won't be their downfall – again. While testing the coffee market makes sense in today's world, the way Krispy Kreme is going about it could be improved. Krispy Kreme should also consider making improvements with its current products, address possible partnerships, and find more logical ways to extend its product distribution that fit in today's doughnut world.