After a Recent Swoon, Is the Story Still Intact at Krispy Kreme?

Shares of doughnut aficionado Krispy Kreme Doughnuts (NYSE: KKD  ) fell off their lofty perch in early December after the company forecast 2014 financial results that were slightly below expectations. Krispy Kreme had been enjoying a multiyear share-price expansion, largely a byproduct of better per-store customer volumes. 

Despite competition from Dunkin' Brands Group (NASDAQ: DNKN  ) and Starbucks (NASDAQ: SBUX  ) , the company also has set its sights on more growth in the Asia-Pacific region, recently announcing a business development agreement with Haiya Group, one of China's major retailers. So, can the Kreme keep rising?

What's the value?
Krispy Kreme has been in growth mode over the past few years, primarily in international markets where it has built an operating footprint in more than 20 countries, with large exposures in Mexico and the Middle East. Despite limited expansion in the U.S. recently, the company has piloted a smaller store size, its so-called Hot Shop format, which management hopes will allow it to recharge its domestic growth and reach smaller markets that can't support traditional factory stores. Krispy Kreme has also been attempting to branch out beyond doughnuts, roughly 88% of its sales, with recent introductions of baked goods and a line of espresso beverages.

In FY 2013, Krispy Kreme has posted a solid top-line gain of 9.4%, thanks to greater customer volumes and successful marketing of its premium-priced beverage offerings. In addition, the company's ability to push through menu-price increases, including the most recent one in February 2013, has favorably benefited its gross margin, leading to greater profitability.More importantly, Krispy Kreme's solid operating cash flow has allowed it to fund capital expenditures without taking on debt, the source of which almost led to the company's downfall a decade ago.

Looking into the crystal ball
While Krispy Kreme continues to try to find an effective road map for its U.S. operations, the company's focus remains squarely on its international segment, the area that accounts for almost 70% of its overall store base and virtually all of its recent store openings. Krispy Kreme has been actively building support infrastructure and relationships in key high-population geographies, entering China in 2010 and India in 2013. However, that strategy has the company in a race for brand superiority with some heavy hitters, including doughnut kingpin Dunkin' Brands.

The owner of the Dunkin' Donuts and Baskin-Robbins brands has been on a steady upward trajectory since its July 2011 initial public offering, reporting rising comparable-store sales and a flurry of new product introductions, including breakfast burritos and pumpkin-flavored, single-serve coffee. Like Krispy Kreme, Dunkin' Brands has also been zeroing in on the Chinese market, with stated plans to triple its store base in that country over the next decade.

In FY 2013, Dunkin' Brands reported solid top-line growth, up 6.9%, courtesy of rising comparable-store sales that benefited from an expanded line of sandwiches and premium-priced beverages.  More importantly, Dunkin' Brands' franchise-heavy operating model continues to generate relatively high profitability and consistent operating cash flow, providing the funds for a further expansion of its overall store base. While the company's international Dunkin' Donuts segment has not performed as well as its domestic counterpart, Dunkin' Brands' solid financial position gives it time to find the right product mix for success in each of its 55 international markets.

Of course, an even bigger threat for Krispy Kreme is coffee giant Starbucks, which has built a network of roughly 4,000 stores in the Asia-Pacific geography and has a clear intention of dominating the region. While food offerings have generally been a weakness for Starbucks, its 2012 purchase of the La Boulange bakery chain looks like it will finally make an impact in that area, as management expects to finish rolling out an overhauled lineup of baked goods to its entire domestic network by the end of FY 2014. 

With its strong financial position and ubiquitous brand name, Starbucks looks primed to use its marketing muscle to win the hearts and minds of the Asia-Pacific region's customers, following the script that it used in the U.S.

The bottom line
The love of coffee and doughnuts seems to be a global trait, evidenced by the success of U.S. retail chains in international markets. While Krispy Kreme seems to have a good market position with its trademark doughnuts, the company's recent negative comparable-store sales performance in its international segment should give investors pause, especially after a strong five-year run for its stock price. Given the importance of the international segment to Krispy Kreme's story, investors should wait for a rebound in the segment's sales trend prior to thinking about taking a position.

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